Suppose that the $1 billion of collateral in Question 14 was divided into a PAC bond with a par value of $800 million and a support bond with a par value of $200 million

Will the PAC bond in this CMO structure have more or less protection than the PAC bond in Question 14?

The PAC bond in the structure of $800 million versus $200 million will have less protection that $700 million versus $300 million. This is because $300 million support is greater than $200 million support. Also, the $300 million has a less amount of PAC bonds to support ($700 million versus $800 million). In general, more supports bonds will offer greater protection. This is because the key to the prepayment protection offered by a PAC bond is the amount of support bonds outstanding. If the support bonds are paid off quickly because of faster-than-expected prepayments, there is no longer any protection for the PAC bonds. In fact, if the support bond is paid off, the structure is effectively reduced to a sequential-pay CMO.

The support bonds can be thought of as bodyguards for the PAC bondholders. When the bullets fly (i.e., prepayments occur) it is the bodyguards that get killed off first. The bodyguards are there to absorb the bullets. When all the bodyguards are killed off (i.e., the support bonds paid off with faster-than-expected prepayments), the PAC bonds must fend for themselves: they are exposed to all the bullets.