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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

A planned amortization class (PAC) CMO has a PAC tranche and a support tranche. Prepayments run well above the upper bound of the PAC collar for an extended period, and the support tranche is fully paid off early. What is the most likely consequence for the PAC tranche?

The PAC tranche's protection fails and its average life may shorten. PAC stability depends on support tranches absorbing prepayment variability. Once the support tranche is retired, excess prepayments flow to the PAC, so it receives principal faster than scheduled.

  1. AIts cash flows are no longer protected and its average life may shortenCorrect
  2. BIts cash flows are unaffected because the PAC schedule is guaranteed
  3. CIts average life lengthens because it receives less principal
  4. DIts coupon is reduced to the collateral rate

Explanation

The PAC's protection comes from the support tranche absorbing excess or shortfall principal. Once the support tranche is exhausted, the PAC loses that buffer and receives the excess prepayments, so its average life contracts. Lengthening would occur with slow prepayments, not fast.

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