How do CMO tranches redistribute prepayment risk, and what are PAC vs. support tranches?
CFA Level II introduces collateralized mortgage obligations (CMOs) as a way to carve up MBS cash flows. I understand that different tranches get paid in sequence, but I'm confused by PAC tranches and support tranches. How do they redistribute the prepayment risk that exists in the underlying pass-through?
A CMO takes a mortgage pass-through pool and redirects its cash flows into multiple tranches (classes) with different risk profiles. The goal is to create securities that better match investor preferences for maturity and prepayment exposure.
Sequential-Pay CMO (Simplest Structure):
All principal payments (scheduled + prepayments) go to Tranche A until it's fully retired, then to Tranche B, then C, and so on. All tranches receive interest on their outstanding balance.
Example — Oakmont Mortgage Trust CMO:
Underlying pool: $400M of 5.5% mortgages
| Tranche | Par Amount | Priority |
|---|---|---|
| A (Short) | $120M | Receives all principal first |
| B (Medium) | $100M | After A is retired |
| C (Long) | $100M | After B is retired |
| Z (Accrual) | $80M | Accrues interest; receives principal last |
Tranche A might have an average life of 3 years, B around 7 years, C around 12 years, and Z around 18 years. The pass-through itself would have had a single average life of ~10 years.
PAC Tranches (Planned Amortization Class):
PAC tranches take prepayment risk redistribution further. They are designed to have a predictable principal repayment schedule as long as actual prepayments stay within a specified band.
How PAC Works:
- Define a PSA band (e.g., 100-300 PSA)
- Calculate the principal cash flow at each boundary
- The minimum of the two at each month becomes the PAC schedule
- The PAC tranche receives principal according to this schedule
- A support tranche (companion) absorbs all the variability
PAC vs. Support Tranche Risk:
| Feature | PAC Tranche | Support Tranche |
|---|---|---|
| Prepayment risk | Very low (within band) | Very high |
| Average life stability | Stable | Highly variable |
| Yield | Lower (compensates for protection) | Higher (compensates for risk) |
| Price volatility | Low | High |
| Negative convexity | Minimal | Extreme |
What Happens Outside the Band?
If prepayments exceed the upper band (e.g., above 300 PSA), the support tranche is retired quickly and can no longer absorb excess prepayments — the PAC tranche then begins to receive faster-than-scheduled principal, losing its protection. This is called "breaking the PAC."
Z-Tranche (Accrual Tranche):
The Z-tranche receives no cash flow initially — its interest is accrued and added to its principal balance. Once all prior tranches are retired, the Z receives all remaining cash flows. It acts like a zero-coupon bond initially, then converts to a current-pay bond. Pension funds and insurers like Z-tranches for their long duration.
Exam Tip: If the question asks which CMO tranche has the most prepayment protection, it's the PAC. If it asks which has the most prepayment risk, it's the support tranche. The Z-tranche has the longest duration.
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