Following are questions and things I’m having trouble confirming about PAC CMOs. I’ve read both CFAI and Schweser on the topic…maybe work is just getting the best of me 1) “With a more narrow effective collar, the less prepayment protection there is” Is this because under a narrow collar, the support tranche is more vulnerable to changing/extreme levels of PSA speeds? Example: Effective goes from 100-300PSA to 150-250 PSA So now if the PSA varies as it did under the 100-300 PSA, the support tranche won’t be able to take the damage as well? 2) “Even if PSA stays within the initial collar for the entire life, supporting tranche may contribute principal OR be given excess principal” Why does the supporting tranche either given excess principal or contribute towards principal? I don’t understand. 3) “Larger effective collar = more protection” Simply because if the PSA speed deviates more widely, the supporting tranche is “tougher” and will be able to take the blows (prepayments)? 4) “A shorter PAC tranche, the more protection it gets and the wider the effective collar” Why? Does it mean because a shorter tranche matures faster, there’s less likelihood the PAC speed could fluctuate and kill the protection before the PAC tranche is fully paid? I’m don’t quite get this. Thanks in advance for any help. I’m currently reading up again and will answer my own questions if I can come to a definitive conclusion. Other than that, have at it! Happy Friday everyone.
You assessment for #1 & #3 are correct. Another way of thinking about it, is the narrower the PAC collar, the more prepayment protection required to realize that collar. #2, you really need to understand how PSA works to get this. PSA assumes the prepayment will follow a certain path throughout time. It does not assume prepayment will be at a constant rate. The best way for you to understand this may be to look at a PSA graph. Notice that it shows time on the x-axis and prepayments on the y-axis. Notice how the actual prepayment rate changes as time goes by for. So to follow a certain PSA rate from t=0, the actual prepayment will vary as time goes by. To follow that rate from t=0, at some points it must be above the collar, and at some points it must be below the collar. If it stays the same PSA throughout the life, it is likely prepaying too fast. #4, I think you are correct on your logic there. If it is a shorter maturity, more prepayment will be directed to the PAC tranch. Since the support tranch has to absorb less prepayment, it offers more protection.
I think on #4 - logic should be… you have a shorter PAC tranche, its average life is smaller. A bigger Support tranche. When Prepayments occur - more is divereted to the Support tranche, regular P&I go to PAC tranche (senior tranche). But this process needs to happen for a much shorter time. So likelihood of a Busted PAC is much smaller. job - all prepayments would still go to the Support tranche - not to the PAC as described. Only regular payments would go to the PAC.
job, cpk, thanks for your replies! Your reasoning is supported in CFAI, I just find both books do a poor job explaining my #4. Concerning #2, Job I do believe you are correct. In understanding how a PAC CMO life can vary given differing speeds within the PAC band, it seems natural that if the speed increases or decreases by large amounts, principal payments could be paid or taken away from support tranches. Now some follow up questions… 1) In an ABS with prepayment and credit tranching, I understand that an AAA tranche for example will have senior tranches, senior tranches support and junior/support subordinated tranches to distribute prepayment risk. The whole ABS will have varying grades of groups of these tranches as being AA, BBB, etc. My question is: Does the lowest part of an AAA rated tranche (junior subordinated tranche) have a higher claim on cash flows than the senior tranche of an AA tranche? Or is it that the lowest junior subordinated tranche will always get hit first/cash flows last, no matter what “rated” tranche it’s attached to? 2) In a synthetic CDO I understand that the junior holders get yield from their HQ bond investments and the periodic fee from CDS. My reasoning is that senior holders get the exposure to the reference asset minus the fee they pay on CDS to junior holders. My question is: How does one gain exposure to the senior level of a synthetic CDO? Given that it does not issue securities for ownership, how does one actually get a claim on the reference asset payments?? Thanks in advance! I saw those accounting “challenge” questions…think I need to hit up FSA again. I think I’ve concentrated too much on the whole all-current vs. temporal thing rather than intercorporate investments. Random tip of the day: Trailer fees are paid by a fund manager to the placement agent who raises funds for the manager’s use.
Regarding 1. The lower tranches cannot have a credit rating higher than the senior tranche. The more senior rated tranches generally have higher bond credit ratings than the lower rated tranches. For example, senior tranches may be rated AAA, AA or A, while a junior, unsecured tranche may be rated BB.