Suppose that for the 1st 4 years of a CMO, prepayments are well below the initial upper PAC collar and within the initial lower PAC collar. What will happen to the effective upper collar?
Answer from CFAI:
If the prepayments are well below the initial upper collar ( this means prepayment speed is slower than initial upper collar?) , this means that there will be more support tranches available four years after the deal is structured than if prepayments were actually at the initial upper PAC collar. This means that there will be more support tranches to absorb prepayments. Hence, the effective collar will increase (why?? increase means prepayment speed will be faster? )
The way i understand this is that if prepay speeds are lower than the upper collar, there’s no excess prepayments to be distributed to the support tranches. When excess prepayments are distributed to the support tranches, it has the effect of paying down the support tranches quicker and when the support tranche is fully paid off there is no longer any support to the PAC bond.
So, the less excess prepayments absorbed by the support tranches, the longer they stay outstanding and longer they support the PAC.
First you need to understand what “effective collar” means.
It’s the lowest and highest level of PSA in the future that can be applied to pre-pmt without breaking your PAC schedule.
So If the prepayments are initially well below the initial upper collar, this means that support tranche is being utilized less compared to that under max PSA level. Therefore, the extra cushion that was un-utilized because of the low pre-pmt can be used in the future to absorb even faster/more pre-pmt (so the upper bound of the effective collar increases because now the support tranche can absorb even faster pre-pmt)