CMO Structures: PAC, TAC and Support Tranches

A pass-through pool hands every investor an identical, unpredictable slice of prepayment risk. A collateralized mortgage obligation (CMO) takes that same pool and re-slices it a different way: not by seniority to losses, like an ABS waterfall, but by when principal arrives. The total prepayment uncertainty in the pool does not shrink — it gets concentrated onto some tranches so that others can be engineered to behave almost like ordinary bonds.

The mechanism: a planned amortization class

A PAC tranche is structured around two prepayment speed assumptions, say 100 PSA and 300 PSA (PSA is a standard prepayment benchmark; higher means faster). The deal's structurer calculates, for every future month, the minimum principal the pool would produce at the slow speed and the maximum it would produce at the fast speed, and sets the PAC's schedule to the smaller of the two in every period. As long as actual prepayments stay between 100 and 300 PSA — the PAC's collar — the PAC receives exactly its scheduled principal, no more, no less, just like an amortizing corporate bond.

The support tranche (also called the companion tranche) exists purely to make this possible. When prepayments run fast, the support tranche absorbs all of the excess principal above the PAC's schedule, shrinking rapidly. When prepayments run slow, the support tranche gives up its own principal receipts to make up the PAC's shortfall, effectively lending the PAC money by deferring its own paydowns.

Worked example: inside the collar versus outside it

Take a simplified pool where, in month 24, the PAC's schedule calls for $2.0 million of principal. At 150 PSA (inside the collar), the pool actually produces $2.6 million that month. The PAC still receives exactly $2.0 million; the remaining $600,000 goes entirely to the support tranche.

Now suppose prepayments spike to 500 PSA, outside the collar, because rates fell sharply. The pool might produce $4.5 million that month. The support tranche, having already been shrinking rapidly, may not have enough remaining balance to absorb all of the excess above the PAC's $2.0 million schedule. If the support tranche has already paid down to $1.8 million, it absorbs its remaining $1.8 million and the PAC is forced to take the extra $0.7 million it wasn't supposed to get — the PAC has "busted through" its schedule, and from that point on it behaves like an ordinary pass-through again, no longer protected.

Conversely, if prepayments run near zero, month after month, the support tranche keeps ceding its scheduled principal to keep the PAC on schedule, and eventually the support tranche itself runs out of remaining balance to give — the PAC extends and starts receiving less than its schedule calls for.

A cousin: the TAC

A TAC (targeted amortization class) is a one-sided version of the same idea: it is protected against fast prepayments (it has a schedule it won't exceed on the upside) but not against slow ones, or vice versa, depending on how it is structured. It offers less protection than a PAC but can be priced more cheaply, and structurers use it to fine-tune a deal's overall risk allocation when a full two-sided PAC collar isn't needed.

Where you meet it in practice

CMO structuring is how the MBS market serves investors with very different risk appetites out of the same collateral: pension funds and insurers buying stable-cash-flow PACs to match liabilities, and hedge funds or specialized MBS desks buying support tranches for the extra yield that compensates for absorbing the concentrated prepayment risk. Reading a CMO deal means identifying which class you are looking at, its collar, and how close current prepayment speeds are to breaking it.