In a CMO structure with several PAC bonds, explain why, when the support bonds are paid off, the structure will be just like a sequential-pay CMO

Question

What will be an ideal response?

Answer 1

The PAC bonds and support bonds are formed from the sequential-pay CMO. If the support bonds are paid off earlier than expected, then the structure reverts to a sequential-pay CMO. More details on the sequential-pay structure are supplied below.

The first CMO was created in 1983 and was structured so that each class of bond would be retired sequentially. Such structures are referred to as sequential-pay CMOs. The payment rules dictate that each tranche receives periodic coupon interest payments based on the amount of the outstanding balance at the beginning of the month. However, the disbursement of the principal is made in a special way. A tranche is not entitled to receive principal until the entire principal of the preceding tranche has been paid off. More specifically, the first tranche receives all the principal payments until the entire principal amount owed to that bond class is paid off; then the next tranche begins to receive principal and continues to do so until it is paid off in entirety. This process continues until the last tranche is paid off. Tranches that are paid off later have greater maturities and thus greater average lives.

Although the priority rules for the disbursement of the principal payments are known, the precise amount of the principal in each period is not. This will depend on the cash flow, and therefore principal payments, of the collateral, which depends on the actual prepayment rate of the collateral. An assumed PSA speed allows the cash flow to be projected. The principal pay-down window for a tranche is the time period between the beginning and the ending of the principal payments to that tranche. Tranches can have average lives that are both shorter and longer than the collateral, thereby attracting investors who have a preference for an average life different from that of the collateral.

There is still a major problem: There is considerable variability of the average life for the tranches. However, there is some protection provided for each tranche against prepayment risk. This is because prioritizing the distribution of principal (i.e., establishing the payment rules for principal) effectively protects the shorter-term tranche (which is paid off first) in this structure against extension risk. This protection must come from somewhere, so it comes from the tranches where the principal is paid off later. These tranches benefit because they are provided protection against contraction risk.