What it means
In a mortgage-backed security, many home loans are pooled together and investors are paid from the interest and principal that borrowers pay. The security promises investors a set rate of interest each month, calculated on the balance outstanding.
The pool needs to collect at least that much interest to pay them in full. A shortfall can happen when a borrower repays a loan early, in the middle of a month.
Interest on a mortgage is normally paid in arrears, and the borrower pays it only up to the date of repayment, while the investors are owed a full month of interest on that balance. The difference between the two is a prepayment interest shortfall.
Other causes exist as well. Borrowers may fall behind on payments, loans may be modified to a lower rate, or a servicer may be unable to advance missing amounts.
In some structures the shortfall is covered by the servicer or by a reserve, and in others it is passed on to investors as a reduction in their payment. Shortfalls are small in an individual month but can add up, especially when interest rates fall and many borrowers refinance.
Investors look at how a security's rules allocate shortfalls between senior and junior classes, since lower-ranking classes usually absorb them first. The idea is wider than mortgages.
Any loan or security where the interest received is below the interest owed has a shortfall, for example a loan whose payments do not cover the interest due so that the balance grows. The term simply describes the gap between what was due and what arrived.
For a finance manager, the practical point is that the stated coupon on a security is not a guarantee of cash received. Reading the documents on how shortfalls are shared tells you how much risk you actually carry.
In practice
Real-world examples.
Example
A homeowner sells her house on the 10th of the month and repays the mortgage in full. She pays interest only to that date, but the investors in the loan's security were owed interest for the whole month, so a small shortfall arises. The investor sees the shortfall as a lower payment in the month, not as a loss of the underlying loan.
Example
An investor in a mortgage-backed security receives less interest than expected in a month of heavy refinancing. She checks the offering documents and finds that the servicer covers some of the shortfall and the rest is shared among classes.
Example
A commercial borrower has a loan whose scheduled payment is lower than the interest due for the first two years. The unpaid interest is added to the balance, which is a shortfall that must be recovered later.
Formula
Calculation
Interest shortfall = Interest due - Interest received
Interest due = Balance x Annual rate / 12
A mortgage pool has a balance of $100,000,000 and investors are owed interest at 4.8% a year. Interest due for the month is 100,000,000 x 0.048 / 12 = 4,800,000 / 12 = $400,000.
Several borrowers prepay during the month, and the pool collects only $385,000 of interest. Interest shortfall = 400,000 - 385,000 = $15,000, which is 15,000 / 400,000 = 3.75% of the interest due.Case study
Seen in the real world.
Riverside Mortgage Trust is an illustrative, fictional securitisation holding $250 million of home loans. When market interest rates fell sharply, many borrowers refinanced and repaid their loans partway through the month.
The monthly interest owed to investors was 250,000,000 x 0.045 / 12 = $937,500. Because of the early repayments, only $915,000 of interest was collected, creating a shortfall of 937,500 - 915,000 = $22,500.
The servicer covered $12,500 of that and the remaining $10,000 was passed on to the lowest-ranking investors. In this illustrative story, the senior investors received their full interest, which showed why the ranking of classes in the structure matters. The trustee published the shortfall in the monthly report so investors could see exactly how the amount had been allocated between the servicer and the classes. The finance team at a bank holding the junior class used the report to update its estimate of expected income for the year. The adviser recommended that the investor read the section of the prospectus that explains who covers shortfalls, because that wording varies from one security to another.
Watch out
Common mistakes.
- Assuming the stated coupon is always paid in full, when shortfalls can reduce the cash actually received.
- Treating early repayment as purely good news for the lender, when it can create a gap in interest for the month of repayment.
- Overlooking the ranking of classes, which decides who absorbs the shortfall first.
Questions
People also ask.
What causes an interest shortfall in a mortgage security?
The usual cause is early repayment during the month, though missed payments and loan modifications can also create one.
Who bears the loss?
It depends on the structure, since the servicer may cover part and the rest is allocated to investors, usually starting with the lowest-ranking classes.
Is an interest shortfall the same as a default?
No, a shortfall is a gap in interest in a period, while a default is a failure to meet the obligations of the loan or security.
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