Excess spread

What Is Excess Spread?

Excess spread, within the realm of structured finance, refers to the surplus difference between the interest income generated by a pool of underlying assets and the interest paid to the holders of the asset-backed securities (ABS) issued against that pool. This financial engineering mechanism acts as a built-in margin of safety, designed to protect the asset pool from potential losses and enhance the credit quality of the securitized debt.³¹ It represents the remaining interest payments and other fees collected on an asset-backed security after all expenses, such as servicing costs and investor payments, are covered.

History and Origin

The concept of excess spread gained prominence with the evolution of securitization as a financial practice. Securitization, the process of pooling illiquid assets and transforming them into marketable securities, began to significantly expand in the 1980s and 1990s. Initially, government agencies supported the mortgage-backed securities (MBS) market. To facilitate the securitization of non-mortgage assets, the financial industry developed various credit enhancement techniques, including excess spread, to mitigate risk for investors and attract a broader investor base.³⁰

The use of excess spread became a key structural element, particularly in asset-backed securities backed by credit card receivables, auto loans, and student loans. The financial crisis of 2007-2008 highlighted the importance of robust credit enhancements, and subsequent regulatory reforms, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, aimed to increase transparency and address conflicts of interest in the securitization market.²⁸, ²⁹

Key Takeaways

• Excess spread is the surplus interest collected from underlying assets in a securitization, exceeding the interest paid to ABS investors and other expenses.²⁷
• It serves as a primary form of credit enhancement, providing a buffer against losses from defaults or delinquencies in the asset pool.²⁵, ²⁶
• A higher excess spread generally indicates a greater cushion against potential losses, improving the credit quality and attractiveness of asset-backed securities.²⁴
• Excess spread can be used to absorb losses, cover expenses, or, if not utilized, may be returned to the originator or held in a reserve account.

Formula and Calculation

Excess spread is generally calculated as the difference between the gross yield on the pool of securitized assets and the various costs associated with the securitization. While specific methodologies can vary depending on the asset class and deal structure, a fundamental representation is:

Where:

• Gross Yield on Assets: The total interest and fees generated by the underlying pool of loans or receivables.
• Investor Coupon Rate: The interest rate paid to the holders of the asset-backed securities.
• Servicing Fees: Costs incurred for managing and collecting payments on the underlying assets.
• Other Trust Expenses: Any additional operational costs or insurance premiums related to the securitization trust.²³

This calculation often considers projected cash flows, default rates, and prepayment speeds to determine the expected excess spread.²²

Interpreting the Excess Spread

Interpreting excess spread involves understanding its role as a risk management tool and a measure of a securitization's health. A positive excess spread indicates that the cash flow generated by the underlying assets is sufficient to cover all expenses and investor payments, providing a safety margin. A larger excess spread implies a more robust credit enhancement, offering greater protection against adverse events like loan defaults or rising servicing costs.²¹

Conversely, a declining or negative excess spread signals potential stress within the securitized pool. If the excess spread diminishes, the securitization's ability to absorb losses without impacting investor payments is reduced, potentially leading to downgrades of the securities by credit rating agencies. Investors closely monitor excess spread as a key indicator of the underlying asset performance and the overall stability of their investment. It is a critical component for fixed income investors evaluating asset-backed securities.

Hypothetical Example

Consider a hypothetical securitization of auto loans. A financial institution pools 1,000 auto loans with an average interest rate of 8%. The total principal balance of these loans is $50 million. The institution then issues asset-backed securities with a total face value of $48 million to investors, paying an average coupon rate of 5%. Servicing fees and other trust expenses are projected to be 1% of the principal balance annually.

Here’s how the excess spread would be calculated:

1. Gross Interest Income from Assets: $50,000,000 \times 8% = $4,000,000$
2. Interest Paid to Investors: $48,000,000 \times 5% = $2,400,000$
3. Servicing Fees and Other Expenses: $50,000,000 \times 1% = $500,000$

Excess Spread = Gross Interest Income - (Interest Paid to Investors + Servicing Fees and Other Expenses)
Excess Spread = $4,000,000 - ($2,400,000 + $500,000) = $4,000,000 - $2,900,000 = $1,100,000$

In this scenario, the excess spread is $1,100,000. This amount provides a significant cushion to cover potential defaults or unexpected costs within the loan portfolio, enhancing the security for investors. If the actual loan defaults are less than what the excess spread can cover, the surplus can be used to build a cash reserve or be returned to the originator.

Practical Applications

Excess spread is a fundamental element in various areas of finance, primarily within asset-backed finance and securitization. Its practical applications include:

• Credit Enhancement: Excess spread is a crucial internal credit enhancement mechanism in securitization deals. It acts as a first line of defense against losses on the underlying assets, protecting investors in the issued asset-backed securities. F¹⁹, ²⁰or instance, in a mortgage-backed security (MBS) transaction, if some mortgage borrowers default, the excess spread can absorb these losses before they impact payments to bondholders.
  *¹⁸ Pricing and Valuation of Securities: Issuers and investors consider the anticipated excess spread when pricing and valuing asset-backed securities. A higher or more stable excess spread can lead to lower yields for investors, reflecting the reduced risk, and potentially a higher price for the securities.
  *¹⁷ Risk Management for Originators: For financial institutions that originate loans and then securitize them, excess spread provides a mechanism to manage their retained risk. By structuring deals with adequate excess spread, they can transfer a portion of the credit risk to investors while maintaining a buffer for unexpected downturns.
  *¹⁵, ¹⁶ Regulatory Capital Calculation: In some regulatory frameworks, the presence and amount of excess spread can influence how much regulatory capital a financial institution must hold against its retained interests in securitization transactions. Robust credit enhancements, including excess spread, can reduce capital requirements.
• Servicer Performance Monitoring: The flow of excess spread can be an indicator of the servicer's effectiveness in managing the underlying loan portfolio. Consistent generation of expected excess spread suggests efficient collections and loss mitigation efforts.

Limitations and Criticisms

While excess spread is a valuable credit risk mitigation tool in securitization, it has certain limitations and has faced criticism, particularly in the context of financial crises:

• Dependence on Asset Performance: The effectiveness of excess spread is directly tied to the performance of the underlying assets. If default rates or delinquencies in the asset pool exceed projections, the excess spread can quickly be depleted, exposing investors to losses. This vulnerability became acutely apparent during the 2008 financial crisis, where widespread defaults on subprime mortgages overwhelmed existing credit enhancements, including excess spread.
  *¹³, ¹⁴ Forecasting Accuracy: The calculation of excess spread relies on financial modeling and projections of future cash flows, default rates, and prepayment speeds. Inaccurate or overly optimistic assumptions can lead to an insufficient excess spread, leaving the securitization vulnerable to unexpected stresses. T¹²he complexity of these models can sometimes obscure the true risks.
• Transparency Issues: Historically, the opacity surrounding the quality of underlying assets and the assumptions used to determine excess spread contributed to investor confusion and misjudgment of risk. The SEC has since implemented rules to enhance transparency in asset-backed securities, requiring more detailed loan-level disclosures.
  *¹¹ Moral Hazard Concerns: Some critics argue that the securitization process, including the reliance on credit enhancements like excess spread, can create a moral hazard for loan originators. If originators can offload risk through securitization, they might have less incentive to maintain stringent underwriting standards, potentially leading to a decline in asset quality over time.

¹⁰## Excess Spread vs. Overcollateralization

Excess spread and overcollateralization are both forms of internal credit enhancement used in securitization to protect investors, but they operate differently.

Excess spread refers to the ongoing surplus cash flow generated by the difference between the interest received on the underlying assets and the interest paid to security holders, after accounting for servicing fees and other expenses. It's a dynamic cushion that replenishes over time as interest payments are made. The excess funds can be used to cover losses or build a reserve.

⁸, ⁹Overcollateralization, on the other hand, is a static credit enhancement established at the inception of a securitization. It involves placing a pool of assets into the securitization trust that has a higher principal value than the amount of debt issued to investors. For example, a trust might hold $105 million in loans to back $100 million in issued securities. This initial capital cushion directly absorbs losses before they affect the par value of the issued securities.

⁶, ⁷While excess spread relies on the ongoing positive cash flow differential, overcollateralization provides an immediate, fixed buffer. Often, securitization structures will utilize both excess spread and overcollateralization in combination to provide robust credit protection.

FAQs

What is the primary purpose of excess spread in securitization?

The primary purpose of excess spread is to serve as a credit enhancement, providing a financial cushion to absorb potential losses from defaults or delinquencies on the underlying assets in a securitized pool. This helps protect investors in the asset-backed securities.

⁴, ⁵### How does excess spread protect investors?
Excess spread protects investors by using the surplus interest income from the underlying assets to cover unexpected expenses, such as loan defaults, servicing costs, or administrative fees, before those losses impact the principal or interest payments to the investors.

³### Is excess spread a guaranteed amount?
No, excess spread is not a guaranteed amount. It is a projected surplus based on assumptions about asset performance, interest rates, and expenses. If the underlying assets perform worse than expected (e.g., higher defaults or lower interest collections), the actual excess spread may be lower than projected or even turn negative.

²### What happens if the excess spread is not enough to cover losses?
If the excess spread is insufficient to cover losses on the underlying assets, other credit enhancement mechanisms, such as subordination (where junior tranches absorb losses before senior tranches) or cash reserve accounts, would typically be utilized. If all credit enhancements are exhausted, investors in the asset-backed securities could begin to experience principal losses or interest payment shortfalls.

¹### Can excess spread be returned to the originator?
Yes, if the excess spread is not needed to cover losses or other expenses and exceeds the amount required to build up a cash reserve account to its specified level, it may be returned to the originator or sponsor of the securitization.