Introduction to Securitization

DETERMINING IF ANY PREPAYMENT PROTECTION IS NEEDED

In the illustration of agency CMOs, we explained how certain bond classes can be provided with different levels of protection against certain types of prepayment risk (i.e., contraction risk or extension risk). When the asset pool consists of long-term assets, the securitizer must decide on whether to create bond classes that have prepayment protection. The economics here is based on spreads offered in the market on different types of prepayment-protected bond classes. Consider, for example, two alternative structures. The first has a PAC and support bonds while the second has only sequential pay bonds. Depending on spreads in the market, which in turn depends on the market’s expectations regarding prepayment speeds for the collateral, the weighted average cost will dictate which structure will be selected. Remember that in the PAC structure, the spreads at which protected bonds can be offered will be less than that for the sequential-pay structure. However, the wider spread that must be offered to pay the support bond classes will determine which of the two structures has the higher cost.