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

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.

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.

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