REMIC Structures

The REMIC security appeals to a broader base of investors than traditional MBS due to its flexibility in bringing investment opportunities with different risk-reward levels and investment horizons to institutional investors. Many tranches are designed to reduce an investor's prepayment risk, while others increase risk but offer higher potential yields. The tranche types discussed below are named for their general characteristics and should be closely evaluated on performance under different economic conditions.

REMIC Tranche Types

A REMIC may include a number of classes that are labeled by letters (e.g.. A Class, B Class) and are assigned stated coupon rates, real or notional principal amounts, a final distribution date, and a CUSIP number.

Sequential Pay Classes

Sequential pay classes are the most basic classes within a REMIC structure. Sometimes called "plain vanilla" or "clean pay" tranches for their simple structure, these classes are retired in sequential order, receiving principal payments only when the classes ahead of them in priority have been fully paid. Until they are paid, these classes earn interest on their principal balances at the stated coupon rate.

If prepayments on the underlying collateral are faster than expected when purchased, the principal retires earlier than expected. This shortens the "weighted average life" of the class, which may affect the yield-to-maturity of the security. (The weighted average life (WAL) measures the expected period of time the principal portion of the class will remain outstanding.) Faster-than-expected prepayments lower the yield on a security purchased at a premium; however, if the security is bought at a discount, faster-than-expected prepayments increase the yield. The opposite results occur if the prepayments are slower than expected.

The REMIC structure shown in Figure I creates short-, intermediate- and long-term classes from the underlying collateral, giving investors a choice of maturities. Class A remains a relatively short-term security even if prepayment speeds slow down, while the other classes obtain a degree of call protection since the earlier classes act as a buffer against prepayments.

Planned Amortization Classes (PACs)

Many investors choose to trade higher returns for more stable investment horizons and cash flows. The planned amortization classes (PACs) were designed with these investors in mind. PACs produce a more stable cash flow by redirecting cash flow from faster-than-expected or slower-than-expected prepayments to "support" or "companion" classes. The PAC investor receives principal payments based upon a predetermined schedule (the PAC schedule) that, through supporting classes, can be maintained within a certain range of prepayment scenarios (the PAC band). The "initial" or "stated" PAC band is listed in the offering circular supplement. It is not likely that the underlying securities will prepay at a constant rate within the PAC band. Therefore, the range of prepayment speeds that will maintain the PAC schedule can change from month to month. This is called PAC band drift.

A useful analytical tool for assessing the stability of a PAC tranche is the "effective band", which measures the range of constant prepayment speeds that will maintain the PAC schedule at any point in time. The effective band changes as the supporting classes are retired and the amount of underlying securities that produce principal cash flow decreases.

PAC class stable cash flows translate to a more stable weighted average life and yield-to-maturity than for other REMIC class types. This results in pricing with lower yields than less stable class types, such as sequential pay classes, with similar weighted average lives. PAC classes whose support classes have been eliminated by faster-than-expected prepayments are known as "busted" PACs and are similarly priced as sequential pay classes.

A PAC class is characterized by a specific principal payment schedule (much like a sinking fund on a corporate bond). In allocating principal paydowns from the collateral to the REMIC classes, priority is given to meeting the PAC principal schedule; thus, other classes in the deal, termed support or companion classes, absorb prepayment variations as much as possible. PAC classes essentially remove maturity uncertainty, provided prepayments stay within a given range. As might be expected, companion classes typically have a high degree of weighted average life sensitivity to prepayment changes and tend to be priced at higher yields.

A PAC class's degree of prepayment protection is typically characterized by a PAC band, such as 100% - 300% PSA (Public Securities Association). The PACs principal payment schedule is derived by taking the minimum of the collateral principal payments at two constant speeds; these two speeds constitute the PAC band.

Targeted Amortization Classes (TACs)

TACs are similar to PACs in that they are structured to provide cash flow stability to the investor. The difference is that TAC classes pay to a targeted principal payment schedule that is created based upon a single, constant prepayment rate. TACs offer limited call protection by hedging the payment against faster-than-expected prepayments. (PAC tranches offer both call and extension protection.) If prepayments on a TAC tranche's underlying collateral are slower than expected, the TAC class principal schedule may not be met. The effectiveness of a TAC structure against cash flow volatility depends on whether PAC classes are present in the structure as well as the relative principal amount of the PAC classes. When PACs are present, TACs may act as companion classes; the TAC will therefore have less cash flow certainty. The actual performance of TAC classes depends on the amount and structure of the companion classes within the REMIC. The companion classes redirect cash flow volatility away from both TAC and PAC tranches. The TAC acts as a last line of defense for the PAC classes if companion classes retire. In general, TACs are usually found in REMIC structures that contain PAC classes. Because they provide less cash flow stability than PAC tranches, TAC tranches are typically priced to produce higher yields than PACs but lower yields than companion tranches.

Companion or Support Classes

The vehicle that enables PAC and TAC classes to offer stabilized principal payment schedules is the "support" or "companion" class. Companion classes absorb cash flow volatility and redistribute it away from the scheduled classes. If prepayments are higher than expected and, as a result, available principal exceeds the amount required to make scheduled payments to PAC and/or TAC classes, the excess will be paid to the companion tranches. If prepayments are slower than expected and available principal is inadequate to make scheduled payments to PAC or TAC classes, the companion tranches will not receive principal until shortfalls in scheduled payments to the PAC and TAC classes have been made up. The weighted average life of a companion class is volatile. It generally increases as interest rates rise and decreases as interest rates fall due to the inverse relationship between interest rates and prepayment rates on residential mortgages. The weighted average life of a companion class is mainly a function of the structure and relative principal amounts of the classes it supports.