Suppose that for the first four years of a CMO, prepayments are well within the initial PAC collar. What will happen to the effective upper collar?

What will be an ideal response?

If the prepayments are well within the initial PAC collar, this means that there are more bodyguards (i.e., support bonds) around than was expected when the PAC was structured at the initial collar. This will result in an increase in the upper range of the effective collar. More details are supplied below.

The initial collars are not particularly useful in assessing the prepayment protection for a seasoned PAC bond. This is most important to understand, as it is common for CMO buyers to compare prepayment protection of PACs in different CMO structures, and conclude that the greater protection is offered by the one with the wider collar. This approach is inadequate because it is actual prepayment experience that determines the degree of prepayment protection and the expected future prepayment behavior of the collateral.The way to determine this protection is to calculate the effective collar for a seasoned PAC bond. An effective collar for a seasoned PAC is the lower and the upper PSA that can occur in the future and still allow maintenance of the schedule of principal repayments.

The effective collar changes every month. An extended period over which actual prepayments are below the upper range of the initial PAC collar will result in an increase in the upper range of the effective collar. This is because there will be more bodyguards around than anticipated. An extended period of prepayments slower than the lower range of the initial PAC collar will raise the lower range of the effective collar. This is because it will take faster prepayments to make up the shortfall of the scheduled principal payments not made plus the scheduled future principal payments.
The PAC schedule may not be satisfied even if the actual prepayments never fall outside the initial collar. This is because single PSA speed does not necessarily hold for the life of the structure.

Finally, any prepayment speeds faster than the collar jeopardize satisfaction of the principal repayment schedule and increase extension risk. This does not mean that the schedule will be busted (busted is the term used in the CMO market when a PAC schedule is broken). It does mean that the prepayment protection is reduced.