Securitisation Waterfall

A securitisation waterfall, also called the priority of payments, is the contractual rule that decides who is paid, in what order and how much, from the cash generated by a pool of securitised assets. On each payment date the money collected from the underlying loans or receivables is applied to a list of items from top to bottom. Each item must be paid in full before anything flows down to the next, much as water fills one basin before spilling into the one below.

The waterfall is what turns a single pool of assets into bonds with different levels of risk. It is written into the transaction documents of a securitization and applied by the cash manager or trustee on behalf of the special purpose vehicle that issued the notes. It should not be confused with the distribution waterfall of a private equity fund, which divides profits between investors and the manager.

Although every deal is different, the usual sequence on a payment date is:

1. Taxes and the fees of the trustee, the servicer, the paying agent and other service providers.
2. Amounts due to hedge counterparties, such as payments under an interest rate swap.
3. Interest on the senior tranche.
4. Interest on each mezzanine tranche in order of rank.
5. Topping up any reserve fund to its required level.
6. Principal on the notes, according to the deal's principal rules.
7. Any remainder to the holder of the equity tranche or residual interest.

Many transactions keep two separate waterfalls, one for interest collections and one for principal collections, with rules allowing one to cover shortfalls in the other. Others combine all collections into a single list.

The way principal is repaid has a large effect on risk. In a sequential structure, all principal goes to the most senior class until it is repaid in full, then to the next class, and so on. This steadily increases the protection enjoyed by the senior notes, because the junior classes remain outstanding beneath them. In a pro rata structure, principal is shared among the classes in proportion to their size, which returns money to junior investors sooner but leaves the proportions of protection unchanged.

Many deals begin on one basis and switch to the other. A common design pays pro rata while the pool performs well and reverts to sequential payment if performance deteriorates.

Waterfalls contain tests that change the flow of cash when the assets weaken:

• Performance triggers. If arrears or cumulative losses pass a set level, principal switches to sequential payment or cash is trapped in a reserve.
• Coverage tests. In a collateralised loan obligation, overcollateralisation and interest coverage tests compare the assets and income with the notes outstanding; if a test fails, interest that would have gone to junior classes is redirected to repay senior notes until the test is met again.
• Early amortisation. In revolving deals, such as those backed by credit card balances, a trigger ends the period in which collections are used to buy new receivables and starts repayment.
• Enforcement. After an event of default and enforcement of security, a separate post-enforcement waterfall applies, normally fully sequential.

Subordination through the waterfall is the main form of credit enhancement in most securitisations. Losses on the assets reduce the cash available at the bottom of the list first, so junior holders absorb them before senior holders are affected. The difference between the interest earned on the assets and the cost of the notes and fees, known as excess spread, sits near the bottom and is the first cushion. Overcollateralization and reserve funds add further protection. Rating agencies model the waterfall under stressed assumptions to decide what rating each class can support, and the technique of dividing notes into ranked classes is described under tranching.

Investors need to be able to reproduce the waterfall to value the notes. Offering documents set it out in full, and periodic investor reports show how the cash was applied on each date. In the European Union and the United Kingdom, securitisation rules require the parties to make transaction documents and loan-level data available, and for deals carrying the simple, transparent and standardised label, to provide investors with a liability cash flow model. Errors in applying a waterfall, or ambiguous drafting, have led to disputes between classes of noteholders, particularly over the ranking of swap termination payments after the 2008 crisis.

• European Securities and Markets Authority
• Basel Committee on Banking Supervision