Schweser says that shifting interest mechanism is to address for the change in the level of credit protection provided by junior tranches as prepayments occur in senior/subordinate structure. Junior trances are designed to provide loss protection for senior trances by absorbing prepayments first. it also says that its important to realize that it is used to maintain the desired level of credit risk but comes at the expense of increased contraction risk for the senior tranches. so which is it? Who eats up the pre payments first?
in the shifting interest mechanism, a schedule is set up so that the senior tranches would eat up prepayments first. they have a little chart in schweser- year 1-5 prepayments 100% year 7 70% year 8 60% etc… so early on in the life of the ABS, it’s the sr tranches that eat up any prepayments, hence the increased contraction risk. However, and LOSSES are still eaten up by the junior tranches, so the sr tranches still have some protection against loss to a point. prepayments and losses are not the same thing.
what about this statement? Junior trances are designed to provide loss protection for senior trances by absorbing prepayments first.
well i would say it is wrong, starting with your spelling of “tranches”. Sorry, its Sunday.
i think schweser’s paragraph there is just garbage- go pg 411 of the CFAI text… explained better. the jr classes provide credit protection to the sr tranches- this shifting interest mechanism more or less looks to hang onto that credit/loss protection for the sr tranches by letting the prepayments go to the sr tranches in some schedule (seems like more prepayments early to sr)- that way instead of retiring the jr tranches early and leaving the sr tranches open to a bigger % of potential losses, the sr tranches would get the prepayments- keeps them safer from losses but the trade-off is that they get prepaid earlier, so bigger contraction risk. i don’t think that schweser description does a good job at all.
bannisja- good look, that makes sense thanks for the clarification. to make the reading more fun, i imagined war movie battles when reading the tranche stuff. it’s like additional defense built up (junior tranche), although more troops(junior tranche) will involve them making less money off the war(senior tranches making less money due to prepayment risk, but they will survive due to additional credit risk protection from juniors). would you concur to that nice metaphor?
LOL, whatever makes you remember it. then the jr tranches in reward for going first into battle as the front lines get rewarded with purple hearts and tons of chicks when they get home (or higher interest payments) b/c we love a good man in military with a solid war story? sure, works for me.
haha yes the junior tranches get the good share of the “booty”!
Shifting Interest was a pretty neat concept, but for HEL’s it started going all over my head. I understand that the HEL Floaters use a 1-month LIBOR and variable rate HEL’s use a 6-month LIBOR, so there may be a case where it gets to a point that the collateral (variable rate HEL’s in this case) are not able to generate enough cash-flow for the HEL-Floater investors. Now the thing that I don’t understand is: To avoid this HEL-Floaters must have a coupon rate caps which are variable (called available fund cap). You can think of the available funds cap as a variable cap on Interest Rate adjustment in HEL Floater. . . . If anyone would like to chip-in as to what this really means?
i dont think you need to know all that detail for HEL…