PAC Tranches average, examples, 300, conversion, receive

dirk01

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.

- Robert

ayodayo

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

Rasec

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.

thecfawannabe

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.

chandsingh

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.

- Robert

profil

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

flyinggirl

PAC tranche gets 200

maryli

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.

sameeragarwal

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?

- Robert

onelife1

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?

- Robert