LO 35.2: Explain the terms over-collateralization, first-loss piece, equity piece, and

LO 35.2: Explain the terms over-collateralization, first-loss piece, equity piece, and cash waterfall within the securitization process.
The securitization process issues notes that are structured to meet specific needs of investors by pooling the assets into different classes referred to as tranches. The quality of credit on the lowest rated assets can be enhanced by a method known as overcollateralization. The lowest class of notes is often overcollateralized by issuing notes with a principal value that is less than the principal value of the original underlying assets purchased from the originator. For example, assume a mortgage pool was securitized based on 100 mortgages, but the originator included 101 mortgages in the pool. This issue is overcollateralized by one mortgage. Thus, investors in the mortgage pool can absorb one default before suffering any economic losses.
The first-loss piece is the class of assets with the lowest credit quality. This is the most junior level where losses are first absorbed in the event of a default. The originator often maintains ownership of the first-loss piece. Because the originator still has ownership of this first-loss piece, it is also sometimes referred to as the equity piece (or the equity tranche). The first-loss piece or equity piece is often non-rated and absorbs initial losses.
The cash waterfall process of securitization refers to the order in which payments from the asset pool are paid to investors. Senior tranches are paid prior to making payments to junior tranches. A third party is hired to run tests in order to ensure cash flows are sufficient to pay all outstanding liabilities.
Figure 2 illustrates how cash flows are allocated to the different tranches in the cash waterfall process. If the first coverage test passes, then interest payments are made to
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Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
subordinate tranche levels. However, if a coverage test fails, then the principal of the notes will begin to be paid off starting with the most senior tranche.
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