PAC and Support tranche

Can anyone please explain, if possible giving example, about PAC and support tranche? I think I understood Sequential Pay tranche and accrual tranche but coundnt follow PAC and support tranche. Thanks!!

There are few natural buyers of pass-through securities because of the high prepayment risk which may result in the duration of the cash flows extending or reducing. Investment bankers came up with a bright idea - why not to separate the payments from the underlying into two tranches. Why not to direct the unpredictable prepayments into one tranche (support tranche) and this will keep payments into the other tranche (PAC) on schedule. Now you can sell the PAC tranche pretty much as a regular bond and the support tranche will be very risky but that’s OK because most of the principal will end up in the PAC tranches and only a smaller percentage will be in the support tranches. The caveat is that the PAC tranche will only stay on schedule as long as the prepayments stay within a certain band.

andy’s please take a look at the text. Fabozzi does a wonderful job at this. He uses a bodyguard imagery. The PAC are the big shots with body guards - the support tranch all take all the hits when there is trouble - prepayments. as the troubles mount - premts increase, these body guards dies - rthey are paid off. when they are all dead - paid off, then the chaps in the white house - PAC guys will draw their own pistols and start facing the heat of prepament one after the other. If its not clear let me know…will give you more detail when I get home…

I didn’t like the bodyguard imagery personally. It annoyed me.

black swan i don’t know why it annoyed you. when i read it i thought is this thebest way to write such a text book. …this is what u will use to teach and not put it in a text book…buy heey for it worth it helps me remember the stuff …may i be able to remember it in context on the day. PS: i realise it is easy to confuse sequential-pay with CMO. let be on …guard…without the body…hahahaaaa. apologies black swan!.

Grace and Fourcastles thanks for your detailed comments… Let me summarize it First one to get prepayement heat are the support tranche followed by PAC II and PAC I. When the actual prepayement rate is faster, support tranche absorbs the excess amounts required for the repayement shedule for PAC. The support tranche will eventually be paid off and the principal will then go to the PAC holders. If this occurs, the PAC is referred to as a broken or busted PAC. I was quite confuse in the begining but after solving some problems I think I have got some idea about various tranches. BTW, I found following calculator very useful to visually see in chart how the mortgages work.

So why do you expect more return by investing in a bodyguard than a big wig? I think the analogy is a little strained.

JoeyDVivre Wrote: ------------------------------------------------------- > So why do you expect more return by investing in a > bodyguard than a big wig? Risk vs. return? Bodyguard facing bullets, or bigwig sitting in comfy leather chair? If I loaned money to a body guard I’d demand a pretty high return on it.

That’s a point…