Net Excess Spread in Securitization

[Liming]

Dear David,

I have two questions regarding Net Excess Spread in Securitization. Thank you for helping me out.

1) why Libor was substracted to get the net excess spread? because substracting Libor makes it looks like credit spread but in here we are concerned with what is remaining from the total cash inflow from assets after paying senior tranches and services fees. And what is the point of referring to the Libor rate?

2) does net excess spread in a subordinated debt tranche different from net excess spread in an equity tranche? It seems to have the same effect from two of your separate study materials but I'm just wondering: shouldn't subordinated debt have more senior level than equity tranche and moreover the subordinated debt most of time also pay coupons to investors? Or is it correct to say that when there is no equity in the structure, the subordinated debt will simply acts like a "equity" ?


Thanks!

Liming
5/11/2009

 

[David Harper CFA FRM]

Hi Liming,

I put a screenshot below, to ensure we are referring to the same (although the XLS values can be changed, my default example mimic Culp's example. I try not to be original!)

1) I did not need to subtract Libor, to agree with you. You can see the net excess spread is $1.30 (i.e., agrees with you that "we are concerned with what is remaining from the total cash inflow from assets after paying senior tranches and services fees") and therere is 6.5%...then I have net excess spread = LIBOR + 2.5%. The reason i did this was habit: the costs are expressed as LIBOR + , so i expressed the ROE (return on equity = excess spread/equity, essentially) also as LIBOR+. So, i did that merely for presentation. As Culp shows, we can use algebra:
100*(L + 100 bps) - 100*10bps - 80*(L + 50) = 20*(L+250)
i.e., under this simplified capital structure, the net excess spread = 20*(L+2.5%).
in the below, = 20*6.5% = $1.30
...so, the net excess spread does vary as Libor varies!

2) Re: "shouldn’t subordinated debt have more senior level than equity tranche and moreover the subordinated debt most of time also pay coupons to investors"
Yes, absolutely ... the subordinated debt will typically have coupons and those obligations must be satisfied *before* the net excess spread...the example I use follows Culp in making an unrealistic assumption that the structure only has senior & equity...the equity tranche is sometimes called the "excess spread" note ... so, if subord tranches have coupons, those are liabilities and they are deducted before the excess spread...I *think* there is only one excess spread tranche but I can't say I am sure that's always the case.

http://learn.bionicturtle.com/images/forum/nov5_netexcessspread.png

David