Excess spread

Excess spread

Excess spread, a key concept in securitisation, plays a crucial role in determining the performance and profitability of asset-backed securities, or ABS. It refers to the difference between the interest collected from underlying assets and the interest paid to investors. Excess spread cushions against potential losses and expenses, providing a source of income to the issuer. 

What is excess spread? 

The excess spread is the surplus cash flow produced by a pool of securitised assets, such as mortgage- or asset-backed securities. It stands for the discrepancy between interest earnings earned from the securities’ underlying assets and interest paid to holders of the securities. In other words, it is the spread or margin that the security issuer has made. In the case of defaults or delinquencies in the underlying assets, the excess spread protects the investors by acting as a cushion against losses. Additionally, it may be utilised to improve the assets’ stability and creditworthiness. 

Understanding excess spread 

The excess spread refers to the difference between the interest income generated by a pool of underlying assets, such as loans or receivables, and the interest payments made to ABS, or mortgage-backed securities, or MBS investors.  

The excess spread acts as a protective cushion for the investors. It covers any potential losses arising from defaults or delinquencies in the underlying assets. If the income generated by the underlying assets exceed the interest payments to investors, the excess spread accumulates and provides a buffer against any losses.  

The excess spread is typically distributed among the investors as additional interest payments or retained by the issuer to build reserves. It helps enhance the credit quality and stability of ABS or MBS transactions, as it provides a source of funds to absorb any unexpected losses and ensure timely payments to investors. 

Importance of excess spread 

The excess spread is important for various financial instruments, including asset-backed securities and collateralised debt obligations. It represents the discrepancy between interest revenue derived from the underlying assets and interest payments made to investors. The capacity of excess spread to act as a buffer against prospective losses or changes in the performance of the underlying assets is what gives it its significance.  

Investors are safeguarded from defaults or delinquencies by this type of credit enhancement. Excess spread ensures that investors obtain their anticipated returns and lowers the risk of principal loss by maintaining the stability and creditworthiness of the structured finance instrument. A wider range of investors is attracted because it boosts investor confidence and makes issuing securities with higher credit ratings possible. 

Workings of excess spread 

The excess spread can be viewed as a form of profit for investors, as it represents the amount of money left over after paying for the costs of servicing the underlying mortgages. This excess spread is typically passed on to investors in the form of higher yields or returns. The more excess spread there is, the more profitable the MBS investment will be. However, the excess spread can also be affected by prepayments, which can reduce the amount of interest paid on the underlying mortgages and thus reduce the amount of excess spread available to investors. 

Therefore, excess spread works as a cash flow buffer in ABS or MBS transactions. The excess spread is created when the interest income generated by the underlying assets exceeds the interest payments to investors. This excess cash flow covers any losses due to defaults or delinquencies in the underlying assets. It provides a cushion of protection for investors, ensuring they continue receiving timely interest payments even in the event of adverse developments in the underlying assets. 

Examples of excess spread 

A securitised pool of home loans is a good example of excess spread. Consider a scenario in which a financial institution creates MBS from a collection of mortgage loans. The interest on the MBS is financed by the borrowers’ interest payments on the underlying mortgages. However, the surplus is referred to as excess spread if the interest earned from the borrowers exceeds the interest owed to the MBS investors. The excess spread can cover credit losses, operating costs, or the issuer’s profit. It protects against probable defaults and improves the MBS’s general performance and creditworthiness. 

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