PAC IOs and PAC POs

May 1, 1993

Interest-only planned amortization classes (PAC IOs) were touted as low-risk alternatives to top-grade corporate debt and regular Fannie Mae and Freddie Mac mortgages. However, the market for PAC Its, which one totaled $25 billion, has collapsed. The typical PAC IO has fallen 50% since late 1991 and some are even down as much as 90%. These terrible results have occurred during a bond market rally that produced positive returns of 20% on treasuries over the same period. In the last two years, the worst possible secnarieos occured for PAC IO holders. Rates fell sharply beginning in late 1991, transforming the PAC IOs from stable PACs to unstable IOs, for which the market had fallen apart. Unfortunately investors, thinking they were getting stable PAC bonds, settled for trivial spreads over regular mortgage-backeds, not understanding the huge risk they were taking. Investors undertook this risk or as little as 25 basis points over a standard Ginnie Mae mortgage. At the same time, some research papers written by Wall Street experts were touting the attractive characteristics of PAC IOs and indicating that the spreads should get even smaller. This episode illustrates the importance of analyzing CMO tranches independently using dynamic prepayment scenarios and a state-of-the-art CMO model. The behavior of a CMO tranche depends on various factors: the underlying collateral, the CMO deal structure, the position of the tranche in the deal, and the principal distribution rules, among others. Seemingly similar tranches can have very different risk-return characteristics. CMOs are complex securities. One should analyze them in a deal context using dynamic prepayment scenarios. Barra's FASTCMO program not only can enter and analyze recently issued CMO deals, it can analyze the effect of various factors that affect the risk-return performance of the tranches of existing deals.