Describe how a securitization's waterfall is organised.
The idea
A securitization waterfall is the contractual order in which collected cash is paid out. Interest collections typically pay senior fees (servicer, trustee) first, then senior note interest, then mezzanine interest. Any residual excess spread goes to the equity tranche, possibly after the tests described in other notes. Principal collections are applied either sequentially, where the senior tranche is repaid completely before the next one receives anything, or pro rata, where every note is repaid in proportion to its balance. Many deals pay pro rata until a trigger such as cumulative losses is breached and then switch to sequential. When cash is short, the shortfall falls on the lowest-priority claim that is due, so equity first, then mezzanine. Exam point: always pay in priority order and stop when the cash runs out. Do not share a shortfall pro rata unless the deal says so.
Formulas
Subordination of the senior tranche
subordination = 1 − senior balance ÷ pool balance
- senior balance
- the senior tranche's outstanding principal
- pool balance
- the collateral pool's current balance
Sequential payment shrinks the senior balance faster than the pool, so subordination grows. Use the current pool balance, not the original.
A practice question
In a typical securitization interest waterfall, which payment ranks first?
- Interest on the senior notes.Why not: Senior note interest is paid after the senior expenses and fees have been paid.
- Interest on the mezzanine notes.Why not: Mezzanine interest comes after the fees and the senior interest.
- Senior fees such as those of the trustee and servicer. - correct
- Distribution of excess spread to equity.Why not: Equity receives only the residual after all senior claims and tests.
The waterfall pays the costs of running the structure first, then the senior notes, then the mezzanine, and the equity holder receives what is left. Each claim is paid in full before the next one starts.
A harder one
In a period the pool produces interest collections of USD 49 million. Fees are USD 3 million, senior interest due is USD 30 million and mezzanine interest due is USD 20 million. The waterfall pays strictly in order of priority. How much interest does the mezzanine tranche receive?
- USD 16 million - correct
- USD 20 millionWhy not: Pays the mezzanine its full coupon, ignoring that cash remaining after fees and senior interest is only USD 16 million.
- USD 19 millionWhy not: Pays no fees first (49 - 30) and so gives the mezzanine USD 3 million too much.
- USD 18.4 millionWhy not: Shares the USD 46 million left after fees pro rata between senior and mezzanine instead of paying senior first.
Cash after fees is 49 - 3 = 46. The senior takes its 30 in full, leaving 46 - 30 = 16 for the mezzanine, which is 4 short of its coupon. Equity receives nothing.
The hardest tier
A deal pays principal pro rata between a USD 700 million senior and USD 200 million mezzanine tranche, but switches to sequential payment when a cumulative loss trigger is breached. The trigger has been breached and USD 60 million of principal is collected. What is the senior tranche's balance after distribution (closest to)?
- USD 653.3 millionWhy not: Applies the pro rata split (senior share 700/900) although the trigger has switched the deal to sequential payment.
- USD 700.0 millionWhy not: Assumes principal is diverted away from the senior tranche after a trigger, when sequential payment sends it first to the senior.
- USD 640.0 million - correct
- USD 686.7 millionWhy not: Gives the senior the mezzanine's pro rata share (200/900) of the principal instead of all of it.
After a trigger breach the structure is sequential, so all USD 60 million goes to the senior: 700 - 60 = 640. Pro rata would have given 60 x 700/900 = 46.7 and a balance of 653.3.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Structured Credit Risk
- Outline the usual kinds of structured products.
- Outline how tranching works and how credit losses are spread across tranches in a securitization.
- Name the chief parties taking part in securitizing assets, and spell out where their interests may clash.
- Work through and evaluate the first iteration or two of interim cashflows for a securitization split into three tiers.
- Spell out how excess spread is dealt with in a securitization structure, and work out the overcollateralization account's value as each year ends.
- Account for the tests a custodian runs on excess spread at each year end to decide what cash flows to the overcollateralization account and to equity noteholders.
- Spell out a simulation-based way of arriving at credit losses for each tranche of a securitization.
- Show why a securitization's credit risk depends on the default probabilities and default correlations of its collateral.
- Account for how tranche default sensitivities are gauged.
- Spell out the factors of risk to which structured products are subject.
- Show what is meant by implied correlation and the way it can be gauged.
- Name the motives behind the use of structured credit products.