Credit Risk Management Practice Exam

In a three-tiered securitization structure, when does the equity tranche receive payments?

1. When the senior tranche payments exceed expectations

2. Only if excess spread is greater than zero

3. At all times, regardless of cash flow

4. After all other tranches have been paid

The correct answer is: Only if excess spread is greater than zero

In a three-tiered securitization structure, the equity tranche receives payments only if the excess spread is greater than zero. The equity tranche is typically the first to absorb losses, but it is also positioned to capture any excess cash flow generated from the underlying assets after the senior and mezzanine tranches have been paid their scheduled payments. Excess spread refers to the difference between the income generated from the underlying assets and the payments required to service the senior and mezzanine tranches. Only when this excess spread is positive do the equity tranche holders receive payments. This aligns the risk and return profile for equity tranche investors, as they are incentivized to take on greater risk in exchange for potentially higher returns when the cash flow situation is favorable. In this context, the senior tranche typically has a priority claim on cash flows, meaning it must be fully satisfied before any payments can be made to the equity tranche, further underscoring that payments to the equity tranche are contingent upon the performance of the underlying assets.