PAC Tranches

A little confused how these operate. Assume the example in the book PSA 90-300. If the actual prepayment is inside the collar, say PSA 200, how much does the PAC participant receive – the minimum amount (90 or 300), or 200? Also, are we supposed to be able to convert PSA to average maturity? I see the conversion being shown in various examples, but I haven’t located a formula for doing so. I have other questions, but I’m so confused right now that I can’t formulate them.

Let me rephrase the above post (my edit time expired). If the actual prepayment is inside the collar, say PSA 200, the PAC I participant receives the minimum amount (PSA 90 or 300 as the case may be). In that case, the support tranche absorbs the contraction. Right? If the prepayment is outside the collar, the PAC tranche absorbs the contraction or the extension, right? What would be an example where the support tranche absorbs the extension?

The companion tranche absorbs the contraction or the extension risk, the payments to the PAC tranche are limited by the prepay collar.

Regarding my question about extension risk: If the PAC tranche is already paid at the minimum point of the collar (say PSA 90), how is extension risk mitigated by Support? PSA would have to drop below 90, and then you’d be outside the collar. Also, are we supposed to be able to convert PSA to average maturity? I see the conversion being shown in various examples, but I haven’t located a formula for doing so.

if the actual prepayments are below the collar, then the principal paid to the support tranche is directed to the PAC. this means that more of support bond is outstanding (or the holders of the support bond have an extension risk) I doubt they will ask us to compute the WAL for a PAC… you will need to compute the principal paid down every month using the 2 different psa’s and pick the one with the lower payment.

Here’s what is tripping me up. The purpose of the collar it to mitigate prepayment risk – contractions and extensions. Conceptually, this works so long as actual prepayments fall within the effective collar. What confuses me is the fact that the PAC normally receives the minimum side of the collar band, not some other point in the band. To my understanding, this protects contraction risk only (prepayments inside the collar will always exceed the minimum). Extension risk is only mitigated when prepayments fall below the lower bound, and by definition you’re outside the collar. So how does this structure reduce extension risk for PAC holders?

The PAC could receive an amount within the collar band, not necessarily at the bare minimum. If the PSA is 200, then the PSA is 200. Not arbitrarily 90 (the lower end of the band). If it faces extension risk, then the junior tranches eat the loss first and senior gets the bare minimum of the collar. Maybe I’m not understanding your question, because it seems pretty straight forward to me.

At the risk of sounding totally lost, let’s assume the collar is PSA 90-300, but the actual payments are running more like 200 (somewhere in the middle of the collar), and we’re in the early days. What does the PAC tranche get – 90?

PAC tranche gets 200

if PSA is 305, support tranche absorbs 5. if PSA is 85, Support tranche feed 5 to pac.

the PAC collar is somewhat confusing, it doesn’t mean the holder gets the principle in between the range. The cashflows are predefined in the sense that the holder always get the minimum of the principle as defined by the lower and upper range of the collar. so it’s effectively Ppac = min(PrinclowPSA, PrinchighPSA). If the actual prepays are higher than the scheduled payment, then the Ppac gets paid to the PAC holder and the excess goes to the companion tranche (if the prepays are consistently high and the companion gets paid down then there is no support for the PAC and the actual cashflows go to PAC…the busted PAC), if the actual prepays are lower then the Ppac still gets paid out but the principle to the companion is delayed (and hence the extension risk).

passme, are you certain you’ve got this right? Refer to Exhibit 17 on page 389. This is an example of a PSA 90-300 based on Exhibit 13, but the cash flows are assumed to be 165. The paydown on the A-F tranches mirrors the minimum principal payments as per Exhibit 13. passme Wrote: ------------------------------------------------------- > PAC tranche gets 200

hmm…i better review

to be fair, I had to read the section at least a dozen times, and I’m still not certain of everything. I’m trying to understand how the support protects the PAC from extension risk.

So, if we can all agree that the PAC is supposed to receive the bottom end of the collar, I’m curious under what scenario would extension risk be mitigated.

Robert, This had me confused for a while too, but I think this will make sense. Here is an example of support bonds providing protection against extension risk. Let’s say in Month 5, the prepayment falls short of schedule (increased extension risk). Note that the support bonds will not receive any principal payments while PAC receives at least some. Then in Month 6, there is an inflow of prepayment and the entire cash flow will go to PAC until amortization schedule is back on track. Ultimately, PAC receives more prepayment than a bond with sequential-pay structure would under this lower-than-expected prepayment schedule.

Extension risk is protected, because as long as the prepayment speed falls between the bands, support tranche covers the shortfall of prepayment. PAC still gets their principal and interests as planned, thus their extension risk is protected. If the prepayments are so low that it’s outside the bands, however, the effective collar will adjust and the price of the PAC will change, although probably not much.

This has just started to confuse me too. I think passme was incorrect above, but I think he knows he was. My 2 questions: 1) If the range is 90-300 PSA, and every month it is consistently 90 PSA, will the support tranche have enough to cover the PAC tranche and ensure there is no extension risk? If so then I think I get it. 2) How is the support tranche paid off? Pg. 389 (volume 5) in the text has an example of PAC & Support tranche payoffs with 165 PSA for the life of the investment. For the life of me I cannot see how they get the principal amounts paid each month. Can anyone? Thanks, Pistol