Redistributing Prepayment Risk among Investors

A

The correct answer is C. The analyst's statement is correct with respect to both the redistribution of risk and the reduction of total prepayment risk in a collateralized mortgage obligation (CMO).

A collateralized mortgage obligation is a type of mortgage-backed security that pools together a group of mortgage loans and issues different classes or tranches of securities backed by these mortgages. Each tranche has different characteristics, such as different interest rates, maturities, and payment priorities.

1. Redistribution of Risk: CMOs are structured in a way that redistributes prepayment risk among investors with different risk tolerances. Prepayment risk refers to the uncertainty of mortgage borrowers paying off their loans earlier than expected, such as through refinancing or selling their homes. When borrowers prepay their mortgages, it affects the cash flow and expected return to the investors in mortgage-backed securities.

In a CMO structure, prepayment risk is divided among different tranches. Some tranches, often called the "support" or "slow-pay" tranches, are designed to bear the brunt of prepayment risk. These tranches typically have longer average lives, meaning they receive cash flows from the underlying mortgages for a longer duration. On the other hand, other tranches, such as the "principal" or "interest-only" tranches, are structured to be more sensitive to prepayments and have shorter average lives.

By allocating prepayment risk among tranches with varying characteristics, the CMO redistributes the risk according to the preferences and risk tolerances of different investors. Investors who are more risk-averse can invest in tranches with more predictable cash flows and reduced exposure to prepayment risk, while investors seeking higher potential returns can invest in tranches with greater prepayment uncertainty.

2. Reduction of Total Prepayment Risk: The structure of a CMO also aims to reduce total prepayment risk for all tranches collectively. By dividing the mortgage pool into separate tranches with varying payment priorities and characteristics, the CMO can mitigate the risk of concentrated prepayments affecting all investors equally.

When prepayment risk is spread among different tranches, the impact of prepayments on each tranche is reduced. The slower-paying tranches provide a buffer against sudden and substantial prepayment activity. As a result, the total prepayment risk for all tranches combined is reduced compared to a scenario where all investors are exposed to the same level of prepayment risk.

In summary, a collateralized mortgage obligation (CMO) achieves the dual objective of redistributing prepayment risk among investors with different risk tolerances and reducing total prepayment risk for all tranches. This structure allows investors to choose tranches that align with their risk preferences and provides a more stable cash flow profile for the entire CMO structure.