Introduction to Securitization

NOTIONAL INTEREST-ONLY BOND CLASSES

In all of the structures discussed thus far, the coupon rate for all of the fixed rate bond classes was set at 5.5%. Unless the yield curve is flat, it is unlikely that every bond class will have the same coupon rate. For example, consider Structure 1. Suppose that the yield curve is such that the shorter term bond class in the structure, bond class A, can be offered at par value with a coupon rate of 4.5%. This means that if the structurer creates a 5.5% coupon rate for bond class A, the bond must be sold at a premium to par. It is well known that investors are reluctant to purchase newly issued MBS at a premium above par. The reason is that early prepayments will result in an immediate capital loss. Hence, structurers are reluctant to create premium bond classes. Instead, structurers will strip off the excess interest (that is, the interest that exceeds the amount necessary to create a bond class to sell at par) and can create an interest-only bond class as follows.

Suppose in Structure 1 a 4.5% coupon rate would be required to sell bond class A at par. Since the par value of bond class A is $320,925,000 and the coupon rate from the collateral is 5.5%, the interest for bond class A is $17,650,875. However, if bond class A is issued with a coupon rate of 4.5%, then the total interest to be paid to the holders of bond class A is $14,441,625. The excess interest is $3,209,250 ($17,650,875 - $14,441,625). From this excess interest an interest-only ...