interest, referred to as "excess spread", is placed into a "spread account" until some or all of the bonds in the deal mature. If some of the mortgage loans go delinquent or default, funds from the excess spread account can be used to pay the bondholders. Excess spread is a very effective mechanism for protecting bondholders from defaults that occur late in the life of the deal because by that time the funds in the excess spread account will be sufficient to cover almost any losses. Prepayment tranching The principal (and associated coupon) stream for CMO collateral can be structured to allocate prepayment risk. Investors in CMOs wish to be protected from prepayment risk as well as credit risk. Prepayment risk is the risk that the term of the security will vary according to differing rates of repayment of principal by borrowers (repayments from refinancings, sales, curtailments, or foreclosures). If principal is prepaid faster than expected (for example, if mortgage rates fall and borrowers refinance), then the overall term of the mortgage collateral will shorten, and the principal returned at par will cause a loss for premium priced collateral. This prepayment risk cannot be removed, but can be reallocated between CMO tranches so that some tranches have some protection against this risk, whereas other tranches will absorb more of this risk. To facilitate this allocation of prepayment risk, CMOs are structured such that prepayments are allocated between bonds using a fixed set of rules. The most common schemes for prepayment tranching are described below. Sequential tranching (or by time) All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. There are several reasons that this type of tranching would be done: The tranches could be expected to mature at very different times and therefore would have different yields that correspond to different points on the yield curve. The underlying mortgages could have a great deal of uncertainty as to when the principal will actually be received since home owners have the option to make their scheduled payments or to pay their loan off early at any time. The sequential tranches each have much less uncertainty. Parallel tranching This simply means tranches that pay down pro rata. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount