A threshold rate mechanism is a contractual arrangement that requires the mortgage servicer to set at each point in time the interest rate charged on the variable-rate mortgages in the mortgage collateral pool to a level that is sufficient to generate enough available income to meet the required payments on the securities issued by the securitisation.
A threshold rate mechanism is sometimes referred to as a "floor rate mechanism" or a "minimum rate mechanism".
The threshold rate mechanism is designed to protect the investors in a securitisation from losses in the event that the interest rates on the underlying mortgages fall below a certain level. If the interest rates on the underlying mortgages fall below the threshold rate, the mortgage servicer will be required to increase the interest rates on the mortgages to the threshold rate. This will ensure that the investors in the securitisation receive the payments that they are entitled to.
The threshold rate mechanism is a common feature of Australian residential mortgage-backed securities (RMBS). The threshold rate for an RMBS is typically set at a level that is slightly above the average interest rate on the underlying mortgages. This ensures that the mortgage servicer has some flexibility to manage the interest rates on the mortgages, but it also protects the investors in the securitisation from losses.
Here are some of the applications of threshold rate mechanisms in securitisation:
- To protect investors: The threshold rate mechanism protects investors in a securitisation from losses in the event that the interest rates on the underlying mortgages fall below a certain level.
- To manage interest rate risk: The threshold rate mechanism can be used to manage interest rate risk. For example, an issuer may set the threshold rate at a level that is above the current interest rates. This will help to protect the securitisation from losses if interest rates rise in the future.
- To create new products: The threshold rate mechanism can be used to create new securitization products that meet the needs of different investors. For example, an issuer may issue a securitization with a threshold rate that is designed to appeal to investors who are looking for a predictable stream of income.
It is important to note that threshold rate mechanisms are not without risk. If the interest rates on the underlying mortgages fall below the threshold rate for a sustained period of time, the mortgage servicer may not be able to generate enough income to meet the required payments on the securities issued by the securitisation. This could lead to losses for the investors in the securitisation.