Charta is on Google Play: practise on the go. Get the app
Charta

Explain cash waterfall, equity piece, first-loss piece and over-collateralization as they apply within securitization.

FRM® Part II · Credit Risk Measurement and Management · An Introduction to Securitisation · FRM2.CR.23.b

The idea

The cash waterfall is the set of priority-of-payments rules that decide who is paid first from the pool's collections. Normally the order is senior fees and expenses, then interest on the senior notes, interest on the junior notes, and principal. Whatever remains goes to the residual holder. The equity piece, also called the first-loss piece, is the most junior claim. It absorbs the first losses on the pool and receives the residual cash, so it earns the highest return and carries the most risk. Over-collateralization means the collateral balance exceeds the notes issued, for example 520 of loans backing 500 of notes. The excess is a cushion that absorbs losses before any note is hit. Losses are allocated from the bottom up by seniority, never pro rata. Triggers such as a failed over-collateralization test redirect residual cash to repay senior principal instead of paying equity.

Formulas

Over-collateralisation as a share of the notes

OC = (collateral − notes) ÷ notes

collateral
the collateral balance
notes
the total balance of notes issued

Divide the excess by the notes outstanding, not the collateral, and do not report the ratio of collateral to notes.

A practice question

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

In a securitization, the cash waterfall is:

  1. The schedule of prepayments assumed by rating agencies when they size the poolWhy not: That is a prepayment assumption; the waterfall is about order of payment, not timing of prepayments.
  2. The decline in the pool balance as loans amortize over their livesWhy not: That is amortization of the assets, not the rules that allocate cash.
  3. The process by which all tranches share each loss in proportion to their sizeWhy not: Pro rata sharing would remove seniority; the waterfall pays and allocates losses by priority.
  4. The set of priority-of-payments rules that sets the order in which collections are paid to fees, senior interest, junior interest, principal and finally the residual holder - correct

The waterfall is the documented order of payments. Senior claims are paid before junior claims, and the residual goes to the equity holder.

A harder one

A trust holds loans with a balance of USD 520 million and has issued notes with a total balance of USD 500 million. The over-collateralization, expressed as a percentage of the notes outstanding, is closest to:

  1. 3.8%Why not: Divides the excess of 20 by the collateral balance of 520 instead of the notes outstanding.
  2. 4.0% - correct
  3. 104.0%Why not: Reports the ratio of collateral to notes, not the excess over the notes.
  4. 20.0%Why not: Reports the USD 20 million excess as if it were a percentage.

Over-collateralization is the excess of collateral over notes: 520 - 500 = 20, and 20 / 500 = 4.0% of the notes.

The hardest tier

A securitization collects USD 8.0 million of interest in a period. The waterfall pays senior fees of 0.4 million, then senior note interest of 4.5 million, then mezzanine interest of 2.0 million. Any remainder goes to the equity holder, unless the over-collateralization test is failing, in which case it repays senior principal. The test is failing. How much repays senior principal?

  1. USD 3.1 millionWhy not: Skips the mezzanine interest of 2.0 million, which ranks ahead of the principal diversion.
  2. USD 1.5 millionWhy not: Forgets to deduct the senior fees of 0.4 million, which are paid first.
  3. Zero, because the remainder of 1.1 million still goes to the equity holderWhy not: Ignores the failed test: trapped cash is diverted to senior principal and equity receives nothing.
  4. USD 1.1 million - correct

8.0 - 0.4 - 4.5 - 2.0 = 1.1 million is left. Because the test fails, the 1.1 million repays senior notes and equity receives nothing.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in An Introduction to Securitisation