What is Excess Spread
Excess spread refers to the remaining interest payments and other fees that are collected on an asset-backed security after all expenses are covered. When loans, mortgages or other assets are pooled and securitized, the excess spread is a built-in margin of safety that protects the pool from losses. The issuer of an asset-backed security structures the pool so that the yield coming off the payments to the assets in the pool exceeds the payments out 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 originator or held in a reserve account.
BREAKING DOWN Excess Spread
Excess spread is a method of credit support or credit enhancement. When a deal is being structured to securitize a pool of loans, for example, the 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, as 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 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 rewards.
Excess Spread, Credit Enhancement and the Mortgage Meltdown
Excess spread is one method issuers use to improve the ratings on a pool of assets that are 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: 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 Mortgage Meltdown illustrated how even well structured 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 2007–2008 financial crisis, excess spread was no protection at all for MBS investors.