Overcollateralization is the excess of the mortgage pool balance over the certificate balance and acts as internally generated credit support. Excess spread is used to accelerate the amortization of the outstanding certificate’s principal balance to a level lower than the mortgage pool balance.
Overcollateralization can either be allowed to build over time or be fully funded at closing. If the OC is built over time, excess spread is used to accelerate the paydown of the AAA classes until the target OC amount is achieved. The target OC amount is usually achieved in the early months of the transaction’s life. Conversely, if the OC is fully funded at closing, then excess spread is used to maintain the OC amount. The target OC amount is generally established as a percentage of the original principal balance. The required OC amount varies depending on the underlying collateral composition, structured used and the level of spreads on the liabilities (bonds) issued.
An overcollateralized transaction can sustain losses equal to the amount of current available excess spread and overcollateralization before incurring principal writedowns in the capital structure. For example, assume the transaction structure and a target OC building to 1.3%. Once cumulative losses exceed the OC amount, and if excess spread is insufficient to cover losses in a given period, then subordinated bond investors will incur principal losses.