From the Schweser/CFAI texts, the emphasis on the reading on PAC tranches is clearly that they are shielded from prepayment risk, which is absorbed by the support tranches. However, is the same always true for credit risk as well? Do credit losses always flow from the support tranche up to the PAC classes in this type of structure? Or, are credit losses applied evenly across tranches, unless otherwise specified during the creation of the structure? I realize in practice that support tranches will absorb losses first, but in terms of the CFAI texts and exams, I don’t want to take it as a conceptual given. Thanks.
There is no mention of credit losses in the reading on MBS and PAC structures. The only place they do mention credit events is when they talk of CDOs in the ABS chapter.
This is because most MBS in the US are Agency MBS and they are suppose to have minimal Credit Risk.
Well, they talk about the importance of credit risk as well with CMBS structures. Does anyone have any more input to the original question?
Also, as an aside, what if prepayments completely pay of a subordinate tranche first, and then credit losses occur? Do the senior bonds take the credit losses since the subordinate tranches were paid off?
To answer the original question, I think it would really depend on how the tranches were set up. I’m sure its possible to set up the following structure on a CMO: PAC A1 PAC A2 PAC B1 Support tranch In that set up, the PAC A1 would be the most senior tranch in both terms of credit loss and prepayments. To answer your second quest, yes if the support tranches have been completely paid off, the senior tranches would incur credit losses if credit losses occur. There would be no tranches to absorb those losses for it.
^ This is very correct. Security for each tranche will have respective OAS to it, which will reflect Credit Risk associated with that security. So, investors do realize risk of Credit losses with securities they are buying and are compensated for it by the spread. For agency MBS tranches, OAS may be small compared to non-agency MBS securities. For non-agency MBS, OAS will depend upon credit ratings associated with its respective securities, based on credit enhancements added to them. (of course, other risks that OAS also compensates for are Liquidity and Modeling Risks).