Excess Spread

Excess spread is the surplus cash flow generated by a securitised pool of assets once the costs of the transaction have been met. The loans or receivables in the pool pay interest and fees at one rate; the notes issued to investors pay interest at a lower rate. After deducting the note interest, the servicer's fee and other expenses from the income on the assets, the remainder is the excess spread. It is usually quoted as an annual percentage of the pool balance.

Excess spread is the first line of defence for investors in an asset-backed security. Losses on the pool are absorbed by this surplus before they reduce any reserve fund or tranche of notes, which makes it a form of internal credit enhancement. It is most important in transactions backed by high-yielding assets such as credit card receivables, consumer loans, auto loans and subprime mortgages.

A common way of expressing excess spread after losses is:

• Portfolio yield is the annualised income collected on the assets, including interest and fees.
• Note coupon is the weighted average interest rate paid on all classes of notes.
• Servicing and other fees cover the servicer, trustee and similar costs.
• Net charge-offs are the annualised losses on defaulted assets, after recoveries.

If a pool of credit card receivables yields 18% a year, the notes pay an average of 5%, fees are 2% and net charge-offs are 6%, the excess spread is $18 - 5 - 2 - 6 = 5$ percentage points. Some reports show the figure before losses, sometimes called gross excess spread, which in this example would be 11%.

Each payment date, collections are applied in the order set by the securitisation waterfall. Income first pays senior fees and note interest. What remains is used to cover principal losses in the period, so that the note balance stays matched by performing assets. Any further surplus may be used to top up a reserve account, to repay notes faster so as to build overcollateralisation, or to reimburse earlier shortfalls. Only then is the remainder released to the holder of the residual interest, usually the originator or the equity tranche investor.

Unlike subordination or a cash reserve, excess spread is not a fixed sum set aside at closing. It is earned month by month and, in most structures, is available on a use-it-or-lose-it basis: surplus from good months that has already been released cannot be recalled to cover later losses. Some transactions trap excess spread in a reserve account once performance weakens.

Because excess spread summarises the health of a pool in a single number, it is widely used as a trigger. In revolving credit card securitisations, if the average excess spread over three months falls below zero, an early amortisation event occurs: the revolving period ends and all principal collections are used to repay investors. Higher thresholds may require cash to be trapped in a spread account before that point is reached. Investors and rating agencies therefore follow the monthly excess spread, yield, charge-off and payment rate figures closely.

• Asset yield. Lower interest rates charged to borrowers, promotional rates, or a shift towards safer borrowers reduce yield.
• Losses. Rising defaults in a recession reduce excess spread directly; see write-off.
• Funding cost. If the notes pay a floating rate and the assets a fixed rate, rising market rates squeeze the margin unless hedged with a swap.
• Prepayments. In mortgage pools, borrowers with the highest rates tend to repay first, so the average yield, and with it the excess spread, declines over time.
• Servicing. Poor loan servicing and collections lower income and recoveries.

Rating agencies give credit for excess spread, but less than its nominal amount. They model it under stress, assuming higher losses, faster prepayment of high-yield assets and adverse rate movements, and count only what survives. In prime residential mortgage-backed securities, where margins are thin, it contributes little; in credit card and consumer transactions it can be the main protection.

For banks, future excess spread that an originator has recognised as a gain on sale must be deducted from regulatory capital under the Basel framework, because it is income that may never be received. In a synthetic securitisation, where the assets stay on the bank's balance sheet, a contractual commitment to use future margin to absorb losses for the protection seller is known as synthetic excess spread and carries its own capital treatment under European rules. Accounting standards treat a retained right to excess spread as a financial asset to be valued and tested for impairment.

Excess spread is strongest when it is least needed and can vanish when losses rise, since defaults both reduce income and add charge-offs. Before 2008, many subprime mortgage transactions relied heavily on it, and it eroded quickly as borrowers defaulted or refinanced. Investors therefore treat it as a first buffer that works alongside, and not in place of, hard forms of enhancement such as subordination through tranching.