So the shifting interest mechanism in a senior-subordinated structure establishes a schedule that provides for a higher allocation of the prepayments to the senior tranche in early years. You reduce credit risk but increase prepayment risk. Why would someone actually need the shifting interest mechanism, isn’t the point of the senior-subordinate structure that the subordinated class absorbs prepayments already? And then any amounts beyond the subordinated structure would then automatically move to the senior structure.
The point of the senior-subordinate structure is to allocate credit risk. Very simply, this is the idea that the subordinate bonds absorb losses before the senior bonds.
Over time, due to prepayments and certain other proceeds allocations, the level of subordination to the senior class may change (“shifting interest”). The purpose of the shifting interest mechanism is to allocate prepayments and certain other proceeds such that a target level of subordination for the senior class is achieved.
I get how the senior-subordinate structure allocates credit risk and how the subordinate bonds absorb losses before senior bonds. Why would you want the shifting interest mechanism that allocates payments to the senior tranche, when you want the subordinate tranche to absorb initial losses?
Let’s say you have a senior-subordinate structure of:
Senior: $80 Subordinate: $20
Subordinate interest (subordination or credit enhancement to seniors): $20/($80+$20) = 20% <==note that all else equal, the higher this number is the better it is for the Senior bond
Now, let’s say that $10 of losses come in and the Subordinate class is written down by $10. The new structure looks like this:
Senior: $80 Subordinate: $10
Subordinate interest: $10/($80+$10) = 11%
The Subordinate interest (or credit enhancement to the seniors) has “shifted” from 20% to 11%. All else equal, this is bad for the seniors because they now have less protection.
So, you would need to pay down the seniors by some amount to bring the subordinate interest back up to 20%.
This situation can also arise from excess prepayments to the subordinate and the exact mechanics of hwo it works are laid out in deal documents, but the concept is to need to keep a certain level of protection to the seniors by paying them down earlier than perhaps would have occured otherwise.
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I get your explanation completely and I see how the mechanism works. BUT, i still don’t understand why we would want it there. The whole point of the senior-subordinate structure is that the subordinate absorbs prepayments, so why then would we want to pay down the senior, when prepayment for the senior is exactly what we are trying to prevent?
No, the point of the senior-subordinate structure is to absorb losses, not prepayments (that’s support tranche).
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Okay right, i get it now. Thanks.
nice explanation 
Why would it matter if the subordinate interest remains at 20%, isn’t the protection limited to $20 (full value of the subordinate? I can understand how you would want to allocate prepayments to the Senior class (essentially returning principal back to the investor) but why would they allocate principal losses to the senior when the sub’s total protection is limited to $20?
Yes, protection is limited to $20 on an aboslute basis (ignoring other protection mechanisms). You wouldn’t allocate principal losses to the senior until the $20 is fully written off. Apologies if i misunderstand your question.
But are the prepayments not already allocated to the senior tranches without the shifting interest mechanism? I don’t understand why the level of credit protection changes over time due to prepayments. I would say that the level of credit protection changes over time due to defaults… Can somebody explain that?
GOOD EXPLANATION RO424