Prof Ian Giddy
New York University
The REMIC structure offers issuers a flexible tool with which to design tranches to meet investor needs and respond to market conditions. Certain REMIC tranches have been designed to reduce an investor's prepayment risk. The tranche types described below are defined according to general characteristics; however, investors should carefully evaluate how the security is likely to perform under a range of economic assumptions.
pay (SEQ) classes
Sequential pay classes are the most basic classes within a REMIC structure. They are also called Plain Vanilla, Clean Pay, or Current Pay classes. The principal on these classes is retired sequentially; that is, one class begins to receive principal payments from the underlying securities only after the principal on any previous class has completely paid off. The principal payments, including prepayments, are directed to the first sequential class (A) until it is retired, then the payments are directed to the next sequential class (B) until it is retired. The process continues until the last sequential pay class (C) is retired. While the class A principal is paying down, B and C class holders receive monthly interest payments at the coupon rate on their principal.
When prepayments are faster than the prepayment speed assumed when the security is purchased (at pricing), the principal is retired earlier than expected, thereby shortening the average life of the class. Changes in the average life of the class may affect the yield-to maturity of the bond. "Average life" represents the average amount of time that each principal dollar is expected to be outstanding. If the bond was purchased at a discount (below par), the shortened average life will increase the bond's yield-to-maturity. If the bond was purchased at a premium (above par), the shortened average life will decrease the bond's yield-to-maturity.
The opposite occurs when prepayments are slower than those assumed at pricing-the average life of a sequential pay class will extend. Under this condition securities purchased at a discount will produce a lower yield-to-maturity than anticipated at pricing, while those purchased at a premium will produce a higher yield-to-maturity.
amortization (PACs) classes
PACs are designed to produce more stable cash flow by redirecting prepayments from the underlying securities to other classes called companion or support classes. The PAC investor is scheduled to receive fixed principal payments (the PAC "schedule") over a predetermined period of time (the PAC 94 "window") through a range of prepayment scenarios (the PAC "band"). The schedule will be met only if the underlying securities prepay at a constant rate within the range assumed for the structuring of the PAC. The initial or "stated" PAC band, principal payment schedule, and window of the PAC are set out in the REMIC prospectus supplement.
Cash flow variability from changes in prepayment speed of the underlying securities is redistributed among other classes, but it is not eliminated from the underlying securities as a whole. The integrity of the PAC schedule is directly influenced by the amount and structure of the companion classes, so it is essential to understand the nature of the companion classes in a particular issue when evaluating a PAC.
A REMIC may contain any number of PAC classes. When more than one PAC is present in a REMIC issue, the PACs are classified according to the relative width of their stated bands (e.g., PAC I, PAC II).
The underlying securities are not likely to prepay at a constant rate within the PAC band. The range of prepayment speeds that will in fact preserve the principal payment schedule may change from month to month ("PAC band drift"). The range of prepayment speeds that will maintain the principal payment schedule at any given time is the "effective band." The effective band changes because of the impact of prepayments on the support class(es) and on the amount of underlying securities available to produce principal cash flow. The effective band is more important to an investor than the stated band because it gives the investor an idea of the actual range of prepayment speeds that will protect the schedule.
Sustained periods of fast prepayments may completely eliminate a PAC's outstanding support class(es). When this occurs the PAC is called a "busted" or "broken" PAC. A busted PAC behaves like a sequential pay class and the investor is subject to the same yield fluctuations as a sequential pay class investor. On the other hand, when prepayments are very slow, there may not be enough cash flow to meet the PAC's schedule resulting in an extension of the average life of the class and a negative effect on the investor's yield.
Because PAC classes have less cash flow variability, their average lives and yields-to-maturity are more stable than other REMIC class types. They are priced to yield less than less stable REMIC classes such as sequential pay classes with similar average lives. In addition, all other things being equal, a PAC with a wide band should be priced to yield less than a PAC with a narrower band. Busted PACs are priced like sequential pay classes.
amortization (TACs) classes
TACs pay a "targeted" principal payment schedule at a single, constant prepayment speed. As long as the underlying securities do not prepay at a rate slower than this speed, the schedule will be met. TACs may provide protection against increasing prepayments and early retirement of the investment ("call" or "contraction" risk). In contrast, PACs offer investors both call and extension protection. In some cases, if prepayments increase, excess cash flow will be paid to companion classes and the TAC will pay principal according to the schedule given in the prospectus supplement. If prepayments are slow, the average life of the TAC will extend because there will be insufficient funds available to meet the principal payment schedule.
TACs are usually found in REMIC issues that have PAC classes and they may act as companion classes. The actual behavior of a TAC class depends on the amount and structure of the companion classes and whether or not PACs are present in the issue. The companion classes absorb the cash flow variability redistributed from both the PAC and TAC classes, while the TAC serves to absorb some of the cash flow variability directed away from PAC classes.
TAC investors can expect higher yields than PAC investors because TACs have more cash flow uncertainty and greater extension risk. TACs may be priced to yield less than SEQs because TACs may have more stable cash flow than SEQs.
or support (SUP) classes
Prepayment variability from the underlying securities cannot be eliminated; it can only be redistributed. PACs, TACs, and other scheduled classes rely on companion classes to absorb this variability. Companion classes have the most volatile cash flow behavior, even more than the underlying MBS.
When prepayment speeds fluctuate, the average life of a companion class can change dramatically. Their average lives extend during periods of low prepayments and shorten during periods of faster prepayments. Principal cash flows are paid to any PAC, TAC, or other scheduled class in a REMIC issue before they are paid to companion classes. Any excess principal cash flow is used to pay down the principal on the outstanding companion class(es). If no companion class remains outstanding, then the principal cash flow is used to retire the PACs, TACs, and scheduled classes then outstanding, in order of their stated priorities, without regard to the principal repayment schedule for that class. On the other hand, when principal cash flow is slower than expected, companion classes may not receive any principal during that period.
Since the prepayment behavior of the underlying securities has a direct impact on a companion class, it is important to understand the nature of the underlying securities and how they may be expected to prepay. It is also important to understand the number and type of classes that the companion supports as well as the number of companion classes in a REMIC issue. The more classes that a companion supports, the more volatile its average life will be.
Companion class average lives and yields-to-maturity may vary widely over time. They are priced at a higher yield than more stable classes to compensate investors for that variability. However, if prepayments vary over time, this yield advantage may be lost. For example, faster-than expected prepayments will increase the actual yield-to-maturity on a companion class purchased at a discount, while slower-than-expected prepayments will decrease the actual yield on such a class.
Z class investors receive no cash flow from the security until certain other classes are paid off. Unlike other classes that pay interest each month, interest that would have been paid is added to the principal balance of the accrual class until the applicable previous classes have paid off. Over time the balance grows and the interest earned, but not paid, is calculated upon this increasing balance. Once the previous classes have paid off, the class becomes an interest-paying amortizing class that pays down like a sequential pay class.
In this illustration, the Z class receives no principal or interest payment for the first 14 years. Instead, interest accrues and is added to the outstanding principal balance. After year 14, the Z class begins paying both principal and interest and the principal balance decreases.
Z classes are often the last regular class in a REMIC issue and have long average lives.
only and principal only (IO/PO) classes
REMIC structures can contain two classes that resemble a stripped mortgage-backed security (SMBS). Each class receives a portion of the monthly principal or interest payments from the underlying securities by "stripping apart" the principal and interest cash flow streams. The underlying securities' scheduled principal amortization and prepayments go to the principal only (PO) class. The interest cash flow goes to the interest only (IO) class.
IOs and POs are complex securities that are extremely sensitive to interest rate changes because prevailing rates affect prepayments. Slower-than-expected prepayments (usually associated with rising interest rates) will have a negative effect on the yield of a PO class. Faster-than-expected prepayments (usually associated with falling interest rates) will have a negative effect on the yield of an IO class.
Because 10 classes will produce cash flow to the investor only if the underlying MBS have principal outstanding on which to base an interest calculation, in certain cases, the investor may receive less cash back than invested, resulting in an actual loss on the investment.
and inverse floating-rate (FLT/INV) classes
A floating-rate class (Floater) is structured so that the coupon rate payable to the investor adjusts periodically (usually monthly) by adding a certain amount (the spread) to a benchmark index (the index), subject to a lifetime maximum coupon (the cap). The one-month LIBOR (London Interbank Offered Rate) is the most popular index, but other indices such as the 11th District Cost of Funds Index (COFi) or various constant maturity Treasury indexes have been used.
Inverse floating-rate classes (Inverse Floaters) have coupon rates that periodically adjust in the opposite direction of the index. The coupon payable often is derived by subtracting a calculated amount from a given lifetime cap [i.e., Coupon Life cap - (Multiplier x Index)].
The yield of any Floater or Inverse Floater is sensitive to the rate of prepayments as well as the level of the applicable index, particularly if the coupon fluctuates as a multiple of the index (so-called Super Floaters). Low levels of the index will reduce the yield of a floating-rate class and the interest rate cap will limit the investor's yield when the level of the index is high. Because the rate of interest paid on an inverse floating-rate often varies inversely with a multiple of the index, any change in the index may have an exaggerated effect on the yield to the investor. High levels of the index will significantly lower the yield of an inverse floating-rate class because its interest rate can fall to 0 percent.
Moreover, changes in the level of the index may not correlate with changes in prevailing mortgage interest rates. Some indexes used for floating-rate and inverse floating-rate classes are more sensitive to fluctuations in short-term rates than others. LIBOR is very sensitive to short-term rates. Mortgage interest rates usually respond to longer term rate movements. It is possible that lower prevailing interest rates, which might be expected to result in faster prepayments, could occur at the same time as an increase in the level of the index. Under these high prepayment/high index situations, investors in inverse floating-rate classes may not recoup their initial investment, resulting in an actual loss on the investment.
REMIC issue that contains a Floater also contains an Inverse Floater tied
to the same index. Together, the pair act as a companion class and together
their cash flow behavior can be as volatile as a companion class. Once
the previous classes have paid off or the specified event occurs, the Z
class becomes an interest-paying amortizing class.