Work through and evaluate the first iteration or two of interim cashflows for a securitization split into three tiers.
The idea
To work through interim cash flows for a three-tier structure (senior, mezzanine, equity), go period by period. First compute collateral interest on the balance that is still performing after defaults. Recoveries on defaulted assets are principal cash. Then pay the waterfall: interest due on the senior notes, then on the mezzanine notes. Each coupon is the note's rate × its opening balance. What is left is excess spread, written Excess. Excess = collateral interest − senior coupon − mezzanine coupon. The loss on the defaulted assets each period is written Loss. Loss = defaulted balance − recovery. Losses are written off against equity first. So the equity balance falls, while the mezzanine and senior balances do not until equity is exhausted. Apply principal cash by the deal's rule, usually senior first. Then roll balances forward and repeat. The usual error is charging interest on defaulted assets or using last year's balances in the next period.
Formulas
Excess spread in a three-tier structure
Excess = collateral interest − senior coupon − mezzanine coupon
- collateral interest
- the rate × the performing collateral balance after defaults
- senior coupon
- the senior rate × its opening balance
- mezzanine coupon
- the mezzanine rate × its opening balance
Earn interest only on performing collateral, and use each period's opening balances, not last year's.
Collateral loss in a period
Loss = defaulted balance − recovery
- defaulted balance
- the collateral that defaulted in the period
- recovery
- the amount recovered on it, which is principal cash
Write the loss off against equity first. The recovery is not written off; it repays notes, usually the senior first.
A practice question
A securitization has a performing collateral pool of USD 500 million paying 8 percent. At the start of year 1, USD 10 million of the collateral defaults. Interest is collected only on the performing balance. Closest to what interest is collected in year 1?
- USD 39.2 million - correct
- USD 40.0 millionWhy not: Charges interest on the full USD 500 million, including the defaulted USD 10 million.
- USD 39.52 millionWhy not: Removes only the USD 6 million loss, treating the USD 4 million of recoveries as still earning 8 percent.
- USD 38.4 millionWhy not: Deducts the defaulted amount twice, as if USD 20 million had defaulted.
Performing balance after default is 500 - 10 = 490, and 8% x 490 = USD 39.2 million. Defaulted assets stop paying interest; recoveries are principal cash, not interest.
A harder one
A securitization has collateral of USD 500 million paying 8 percent, a senior tranche of USD 350 million at 4 percent, a mezzanine tranche of USD 100 million at 7 percent and an equity tranche of USD 50 million. In year 1, USD 10 million of collateral defaults and USD 4 million is recovered, a collateral loss of USD 6 million. What is the equity balance at the end of year 1?
- USD 40 millionWhy not: Writes equity down by the full defaulted amount of USD 10 million, ignoring the USD 4 million recovered.
- USD 50 millionWhy not: Assumes no write-down because the notes' coupons were paid in full.
- USD 46 millionWhy not: Writes down only the recovered USD 4 million instead of the USD 6 million loss.
- USD 44 million - correct
Losses are written off against the lowest tranche first. The loss is 10 - 4 = 6, so equity = 50 - 6 = USD 44 million. Check: collateral 490 less debt 346 + 100 = 44.
The hardest tier
A securitization pool is USD 490 million at the start of year 2 and pays 8 percent on performing collateral. USD 15 million of the pool defaults at the start of the year. The senior tranche is USD 346 million at 4 percent and the mezzanine tranche is USD 100 million at 7 percent. Closest to the year 2 excess spread?
- USD 17.2 million - correct
- USD 17.0 millionWhy not: Uses the original senior balance of USD 350 million, though it has fallen to USD 346 million.
- USD 18.4 millionWhy not: Earns interest on all USD 490 million, ignoring the year 2 default of USD 15 million.
- USD 24.2 millionWhy not: Deducts only the senior interest and omits the mezzanine coupon.
Interest = 8% x (490 - 15) = 38.0. Senior interest = 4% x 346 = 13.84; mezzanine = 7.0. Excess spread = 38.0 - 13.84 - 7.0 = 17.16, about USD 17.2 million.
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.
- Describe how a securitization's waterfall is organised.
- Name the chief parties taking part in securitizing assets, and spell out where their interests may clash.
- 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.