Final answer:
In a collateralized mortgage obligation (CMO), the senior tranche is the most secure and prioritized layer for repayment, considered low-risk due to the high credit ratings given by reputable agencies. It was favored by investors for perceived safety but was heavily impacted in the financial crisis leading to the Great Recession.
Step-by-step explanation:
In a collateralized debt obligation (CDO) such as a collateralized mortgage obligation (CMO), the senior tranche is the top priority layer for the distribution of repayments and has the lowest risk compared to the rest of the tranches. Investors in the senior tranche are paid out first from the cash flows generated by the underlying assets, usually mortgages, and have the highest credit ratings provided by agencies such as Standard & Poors, Moody's, and Fitch. These tranches were thought to be very safe, attracting a broad spectrum of investors.
During the financial crisis that led to the Great Recession, the failure of CDOs, including CMOs, and instruments such as credit default swaps (CDSs) played a significant role. The demand for high-interest subprime mortgages increased due to their inclusion in CDOs, which contributed to inflating the housing bubble. When the bubble burst, CDOs, especially those with subprime mortgage-backed securities, lost significant value, causing widespread financial distress.