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Spell out how excess spread is dealt with in a securitization structure, and work out the overcollateralization account's value as each year ends.

FRM® Part II · Credit Risk Measurement and Management · Structured Credit Risk · FRM2.CR.22.f

The idea

Excess spread is the interest collected on the collateral minus the interest due on the notes and fees. Rather than paying it all to equity, many structures first divert some of it into an overcollateralization (OC) account, a cash reserve that absorbs future losses. At each year end, compute collateral value, which is the original balance less cumulative losses, and add the OC balance. Compare that sum with the required level, written Required. Required = trigger × (senior + mezzanine notional). The trigger is a percentage, for example 110 percent. The shortfall is paid into the OC account out of excess spread, but never more than the excess spread available. The OC balance carries forward and counts toward the next test. Typical mistakes are diverting all the excess spread, ignoring the carried-forward balance, or testing against 100 percent when the deal specifies a higher trigger.

Formulas

Required cover in the overcollateralisation test

Required = trigger × (senior + mezzanine)

trigger
the required ratio, such as 110 percent
senior
the senior notional
mezzanine
the mezzanine notional

Compare it with collateral value, the original balance less cumulative losses, plus the OC balance carried forward. Testing at 100 percent when the deal says more is a trap.

Amount paid into the OC account

OC top-up = min(Required − collateral value − OC balance, Excess)

Required
the trigger × senior and mezzanine notional
collateral value
the original collateral balance less cumulative losses
OC balance
the balance already in the account
Excess
the year's excess spread

Floored at zero when the test is met. The diversion can never exceed the excess spread, and the account balance carries forward.

A practice question

From the question bank, with the reason each wrong option is wrong.

In a securitization, excess spread is best defined as:

  1. the difference between the senior and the equity coupons.Why not: Coupons on tranches are the cost side; excess spread is a cash flow from the collateral.
  2. the interest collected on the collateral minus the interest due on the notes and the fees. - correct
  3. the principal collected from the collateral in excess of the senior balance.Why not: That describes principal cash, not the interest margin.
  4. the market yield of the collateral minus the risk-free rate.Why not: This is a credit spread measure, not a cash flow in the waterfall.

Excess spread is the margin between what the pool earns and what the notes and expenses cost. It is the first line of defence against losses and, absent tests, would go to the equity holder.

A harder one

A structure: collateral USD 1,000 million at 8 percent, senior USD 700 million at 5 percent, mezzanine USD 200 million at 7 percent, equity USD 100 million. At each year end, excess spread goes first to the OC account until collateral value (original balance less cumulative losses) plus the OC balance equals 110 percent of senior plus mezzanine notes. Year 1: USD 50 million defaults at the start of the year, 40 percent is recovered, and the loss is USD 30 million. What is the OC account balance after year 1?

  1. USD 27 millionWhy not: Diverts the whole of excess spread (76 - 49) although the shortfall to the 110 percent target is only USD 20 million.
  2. USD 30 millionWhy not: Tops the account up by the loss instead of by the shortfall to the required level.
  3. USD 0Why not: Tests against 100 percent of the notes (USD 900 million, which the USD 970 million of collateral exceeds) instead of the 110 percent trigger.
  4. USD 20 million - correct

Collateral value = 1,000 - 30 = 970. Required = 1.10 x 900 = 990, so the shortfall is 20. Interest = 8% x 950 = 76, notes' interest = 35 + 14 = 49, excess spread = 27 which exceeds 20. OC account = USD 20 million; equity receives 7.

The hardest tier

A structure has collateral of USD 1,000 million paying 8 percent, a senior tranche of USD 700 million at 5 percent and a mezzanine tranche of USD 200 million at 7 percent (USD 900 million of notes in all). Excess spread is trapped in an overcollateralization (OC) account until collateral value (original balance less cumulative losses) plus the OC balance equals 110 percent of the notes. After year 1 the OC account is USD 20 million. In year 2, cumulative losses reach USD 66 million (collateral value USD 934 million) and excess spread is USD 22.2 million. What is the OC account at the end of year 2?

  1. USD 56.0 millionWhy not: Tops the account up by the full shortfall of USD 36 million, although only USD 22.2 million of excess spread is available.
  2. USD 42.2 million - correct
  3. USD 22.2 millionWhy not: Forgets the USD 20 million carried forward from year 1.
  4. USD 36.0 millionWhy not: Reports the year 2 shortfall as the balance, ignoring the cap by excess spread and the existing balance.

Required 990; collateral + OC = 934 + 20 = 954; shortfall = 36. Excess spread is only 22.2, so all of it goes to the account: 20 + 22.2 = 42.2. Equity receives nothing.

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