Excess Spread
Contents
Demystifying Excess Spread: A Comprehensive Guide
Understanding Excess Spread
Exploring the Concept
Excess spread, a crucial term in asset-backed securities (ABS), represents the surplus difference between the interest received by the issuer and the interest paid to the holder. It serves as a protective buffer, ensuring that the pool of assets backing the security remains resilient against potential losses.
Unpacking the Mechanics
How Excess Spread Works
In the realm of securitization, excess spread acts as a safeguard against defaults and non-payments. By structuring the pool of assets to generate yields exceeding investor payments and operational expenses, issuers mitigate risks inherent in asset-backed securities. The level of excess spread is tailored to the underlying asset's default probability, with any unused surplus typically redirected to reserves or returned to originators.
Leveraging Excess Spread for Credit Enhancement
Enhancing Security Ratings
Issuers utilize excess spread to bolster the credit ratings of asset pools, thereby attracting institutional investors. Alongside excess spread, various credit enhancement methods contribute to this goal:
- Cash Reserve Account: A designated account where surplus funds accumulate to cover potential losses.
- Over-Collateralization (OC): Securing the asset pool with collateral exceeding the security's value.
- Subordinated Tranches: Establishing priority claims on cash flows, ensuring senior tranches are shielded from losses.
Lessons from History
The Role of Excess Spread in Financial Crises
While excess spread is designed to fortify asset-backed securities, its effectiveness was questioned during the subprime mortgage crisis of 2007–2008. Despite structured safeguards, systemic failures in borrower vetting and ratings assessments undermined the protection afforded by excess spread, exposing investors to significant losses.