Why is a shifting interest mechanism included in a securitization where the collateral is residential mortgage loans?

Question

What will be an ideal response?

Answer 1

Almost all existing senior-subordinated structures backed by residential mortgage loans also incorporate a shifting interest mechanism. This mechanism redirects prepayments disproportionately from the subordinated bond class to the senior bond class according to a specified schedule. The rationale for the shifting interest structure is to have enough subordinated bond classes outstanding to cover future credit losses. More details are given below.

The basic credit concern that investors in the senior bond class have is that although the subordinated bond classes provide a certain level of credit protection for the senior bond class at the closing of the deal, the level of protection may deteriorate over time due to prepayments and certain liquidation proceeds. The objective is to distribute these payments of principal such that the credit protection for the senior bond class does not deteriorate over time.

The percentage of the mortgage balance of the subordinated bond class to that of the mortgage balance for the entire deal is called the level of subordination or the subordinate interest. As the percentage becomes higher there is a greater level of protection for the senior bond class. The subordinate interest changes after the deal is closed due to prepayments. That is, the subordinate interest shifts (hence the term "shifting interest"). The purpose of a shifting interest mechanism is to allocate prepayments so that the subordinate interest is maintained at an acceptable level to protect the senior bond class.