What Is Excess Spread?

Excess spread is the surplus difference between the interest received by an asset-based security's issuer and the interest paid to the holder. It refers to the remaining interest payments, and other fees, that are collected on an asset-backed security after all expenses are covered.

Understanding Excess Spread

When loans, mortgages, or other assets are pooled and securitized, the excess spread is a built-in margin of safety designed to protect that pool from losses. The issuer of an 澳洲幸运5官方开奖结果体彩网:asset-backed security (ABS) structures the pool so that the yield coming off the payments to the assets in the pool exceeds the payments to investors as well as other expenses, such as insurance premiums, servicing costs, and so on. The amount of excess spread built into an offering varies with the risks of default and non-payment in the underlying assets. If the excess spread is not used to absorb losses, it may be returned to the 澳洲幸运5官方开奖结果体彩网:originator or held in a reserve account. 

Excess spread is a method of credit support or 澳洲幸运5官方开奖结果体彩网:credit enhancement. For example, when a deal is being structured to securitize a pool of loans, these loans are assessed, packaged, and sold with enough excess spread to cover the predicted number of defaults and non-payments. Setting an adequate level of excess spread is tricky for issuers, since investors want to capture as much profit as possible, while the issuer and originator want to avoid losses that would trigger other credit support actions that pull money out of a reserve account or require more 澳洲幸运5官方开奖结果体彩网:collateral to be added to a pool. Investors want some excess spread so that income from the investment is within expectations, but they do not want too much risk protection eating🐷 up all their potential rewar🌳ds.

Excess Spread and Credit Enhancement

Excess spread is one method issuers use to improve the ratings on a꧒ pool of asse💜ts that is being assembled for a deal. A higher rating helps the issuer and makes the resulting security more attractive to institutional investors like pension and mutual funds. Other methods used to enhance an offering include:

• Cash reserve account: This is an account where the excess spread is deposited until the balance reaches a specified level. Any losses are paid out of the account and the excess spread is again redirected to replenish it. 
• Over-collateralization (OC): This is when the assets put into the pool make up a higher value than the actual amount being issued as an asset-backed security. Essentially the extra collateral is a defense against losses provided by the originator of the loans. 
• Subordinated tranches: This is when senior tranches are created with superior claims on the cash flows compared to other tranches. In other words, the subordinated tranches absorb losses first.

Asset-backed securities will use one or more of the above methods to protect against losses and increase the rating of the resulting investment product. That said, the 澳洲幸运5官方开奖结果体彩网:subprime mortgage meltdown illustrated how even well-structured 澳洲幸运5官方开奖结果体彩网:mortgage-backed securities (MBS) can self-destruct when the originators abdicate responsibility for vetting the borrowers whose loans make up the pools and the ratings agencies subsequently fail to catch this systematic failure. In the perfect storm that was the 澳洲幸运5官方开奖结果体彩网:2007–2008 financial crisis, excess spread was no protec♒tion at all for MBS inv🍒estors.