Guys, I am trying to understand the mechanics of the support tranche and how it assists the planned amortizations. Could someone break this down for me in simpler terms? This is the key statement that I am trying to understand:
the certainty of PAC bond cash flow comes at the expense of increased risk to the support tranches.
Any help would be appreciated.
This PAC tranche recieves prepayments according to a defined schedule. Given the inherent uncertainty and unpredictability of prepayments, they way to assure a definied schedule is to have the support bond absorb the excess prepayments. As a consequence, the support tranche is exposed to a higher prepayment risk.
What if not enough funds flow into the support tranche to pay off the amount of prepayments necessary to meet the obligations of the prioritized tranche? Does the support tranche absorb the loss and pay off the prioritized tranche as scheduled? or does it default? If it does support it, where would it get the extra funds from? I understand that if there are more prepayments, it can just keep the excess reserves.
Thanks
I believe the PAC has priority in principal, but the reading is mainly focused on prepayment risk, not risk of losses. The support tranche doesn’t make payments, it’s just a first line of defense and absorbs the risk first.
Suppose that the PAC tranche has a range of, say, 50 PSA to 150 PSA.
If the actual prepayment in a given month lies in the range of 50 – 150 PSA, then the PAC tranche will recieve its normal principle, interest, and the actual prepayment.
If the prepayment in a given month is above 150 PSA, then the PAC tranche will receive its normal principle and interest, plus a 150 PSA prepayment; the remaining prepayment will go to the support tranche (paying down its principle).
If the prepayment in a given month is below 50 PSA, then the PAC tranche will receive its normal principle and interest, plus a 50 PSA prepayment; the shortfall in the prepayment will come from the support tranche’s payment. If the entire payment to the support tranche is insufficient to bring the PAC’s prepayment up to 50 PSA, then it will fall short; there is no other mechanism to add the remaining payment to the PAC.
Once the support tranche is paid off, the PAC loses its prepayment protection.
“Once the support tranche is paid off, the PAC loses its prepayment protection”
This just means that once the support tranche is paid off, the PAC will eventually receive the deferred payment right?
Is there a way to insure this? Let’s say that you sell a structure like this, and because you want to be certain that the PAC receives every payment in a timely fashion, could you insure (pay an outside party) the risk that the prepayment will fall below 50 PSA due to a shortfall from the support tranche?
I don’t see why not, although it’s more likely that you’d simply make sure that the size of the support tranche is sufficient to protect the PAC in all but the most unlikely of prepayment scenarios.
Very good point and thank you Magician.
My pleasure.