Suppose that $1 billion of pass-throughs is used to create a CMO structure with a PAC bond with a par value of $700 million (PAC I), a support bond with a schedule (PAC II) with a par value of $100 million, and a support bond without a schedule with
a par value of $200 million.
Will the PAC I or PAC II have the smaller average life variability? Why?
The PAC II will have greater average life variability. This is because the primary function of PAC II is to support PAC I bonds by allowing them to have more stable cash flows and thus less average life variability. More details are given below.
A support bond can be partitioned so as to create support bond classes with a schedule of principal repayments. That is, support bond classes that are PAC bonds can be created. In a structure with a PAC bond and a support bond with a PAC schedule of principal repayments, the former is called a PAC I bond or level I PAC bond and the latter a PAC II bond or level II PAC bond. Although PAC II bonds have greater prepayment protection than the support bond classes without a schedule of principal repayments, the prepayment protection is less than that provided PAC I bonds.
1.Will the support bond without a schedule or the PAC II have the greater average life variability? Why?
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