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.
The idea
At each year end the custodian tests whether the structure is adequately collateralized and uses the result to route excess spread. Step one: add the collateral value after cumulative losses to the OC account and compare the sum with the required amount. The required amount is a trigger ratio × the outstanding senior and mezzanine notes. If there is a shortfall, excess spread goes into the OC account up to the shortfall. Step two: whatever excess spread remains after that, if any, is released to the equity noteholders. If the excess spread is smaller than the shortfall, all of it is trapped. Equity receives nothing and part of the shortfall remains for the next year. If the test is met, all excess spread flows to equity. The usual errors are paying equity before testing and forgetting that the OC balance counts toward the test.
Formulas
Excess spread released to equity
equity payment = Excess − OC top-up
- Excess
- the year's excess spread
- OC top-up
- the amount trapped in the OC account, the shortfall capped at Excess
Test first, then pay equity. If the shortfall exceeds the excess spread, equity gets nothing; if the test is met, it gets all of it.
A practice question
At each year end the custodian's first test on excess spread is whether:
- the equity tranche has a positive market value.Why not: The test is a coverage test on the collateral and reserve, not a market valuation of equity.
- the senior notes' coupon was higher than the collateral yield.Why not: Coupons relative to yield are fixed by design and are not what the custodian tests.
- collateral value after losses plus the OC account is at least the required multiple of the senior and mezzanine notes. - correct
- the rating agencies have upgraded the mezzanine tranche.Why not: Rating changes are not part of the cash-flow tests.
The custodian compares cover (collateral plus OC account) with the amount required. A shortfall triggers diversion of excess spread into the OC account before anything is released to equity.
A harder one
In a structure with a coverage target of 110 percent, year-end excess spread is USD 27 million and the shortfall in collateral value plus OC account is USD 20 million. How much is paid to equity noteholders?
- USD 7 million - correct
- USD 27 millionWhy not: Pays all excess spread to equity and ignores the test.
- USD 20 millionWhy not: Pays the shortfall to equity instead of to the OC account.
- USD 0Why not: Traps the whole excess spread whenever the test fails, instead of only the amount of the shortfall.
The OC account receives the shortfall of USD 20 million (less than excess spread of USD 27 million), and equity gets the remainder: 27 - 20 = USD 7 million.
The hardest tier
Collateral USD 1,000 million, senior plus mezzanine notes USD 900 million, cumulative losses USD 30 million, OC account empty, excess spread USD 27 million. If the required cover were 100 percent of the notes instead of 110 percent, how much would equity receive at year end?
- USD 7 millionWhy not: Still tests against 110 percent of the notes, which the question has removed.
- USD 20 millionWhy not: Pays equity the amount that the OC account would have received at the 110 percent trigger.
- USD 27 million - correct
- USD 70 millionWhy not: Pays equity the surplus of collateral over notes (970 - 900), though only excess spread can be paid out.
At 100 percent the requirement is 900 and cover is 970 + 0 = 970, so there is no shortfall. All USD 27 million of excess spread is released to equity. Surplus collateral is not distributed, only excess spread.
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
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- Work through and evaluate the first iteration or two of interim cashflows for a securitization split into three tiers.
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- Name the motives behind the use of structured credit products.