FIN30021 Fixed Income and Debts Markets Question 1 What is meant by a cash flow waterfall? Module 9 - ABS Most securitization transactions that employ internal credit enhancements follow a predetermined schedule that prioritizes the manner in which principal and interest generated by the underlying collateral must be used. This schedule, which is explained in the deal's prospectus, is known as the cash flow waterfall, or simply the waterfall. At the top of the waterfall would be cash flows due to senior bondholders (interest and principal, depending upon the principal repayment schedule) as well as some standard fees and expenses (e.g., administration and servicing fee). After the cash flow obligations at the top of the waterfall are met, cash flows down to lower priority classes (those rated AA, A, BBB bond classes and so on). The cash flows associated with the excess spread are all that remain after the scheduled periodic payment obligations are met. The excess spread is the first line of defense against collateral losses, because deals that are structured to have a large amount of excess spread can absorb relatively large levels of collateral losses. If the excess spread is fully eaten away by losses, the next lowest- rated class will begin to be negatively affected by credit losses. Question 2 Explain why the higher the loan-to-value ratio is, the greater the credit risk is to which the lender is exposed. The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property. The higher this ratio is, the less the protection (and the greater the credit risk) for the lender if the applicant defaults on the payments and the lender must repossess and sell the property. Below are more details. If an applicant wants to borrow $225,000 on property with an appraised value of $300,000, the LTV is 75%. Suppose the applicant subsequently defaults on the mortgage. The lender can then repossess the property and sell it to recover the amount owed. But the amount that will be received by the lender depends on the market value of the property. In our example, even if conditions in the housing market are weak, the lender will still be able to recover the proceeds lent if the value of the property declines by $75,000. Suppose, instead, that the applicant wanted to borrow $270,000 for the same property. The LTV would then be 90%. If the lender had to foreclose on the property and then sell it because the applicant defaults, there is less protection for the lender. The LTV has
been found in numerous studies to be the single most important determinant of the likelihood of default. The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default. They will either try to protect this equity by remaining current or, if they fail, sell the house or refinance it to unlock the equity. In any case, the lender is protected by the