Social Sharing
Extended Viewer
PACs: Are Things Always as Simple as they Look?
Nov 1, 1992
CMOs were created to address prepayment risks inherent in a mortgage. Of the various tranches, planned amortization class (PACs) are carved out of a CMO deal in such a way so as to provide the most stability and certainty of cash flows. As a result, most investors think of PACs as straightforward tranches with minimal call and extension risk. Although most PACs are fairly secure, it is useful to be aware of the features of the deal structure that could have a significant impact on performance. In this article we will first look at the commonly used measures for predicting the behavior of PACs, namely, PAC structuring ranges and effective PSA collars. Next, we will illustrate the idea of interest rate collars as a better measure for characterizing the prepayment risks inherent in a PAC. We will then explore some features of the deal structure that affect the performance of a PAC. We will establish the need for thorough analysis within the context of the whole deal, for even straightforward tranches like PACs, to account for tranche interdependencies in complex deals.