Credit Risk Management Practice Exam

What does the term 'cash waterfall' refer to in the securitization process?

1. The structure of tranches in a CDO

2. The method of distributing cash flows to senior and junior tranches

3. The process of calculating investor returns

4. The flow of cash from securitized assets to originators

The correct answer is: The method of distributing cash flows to senior and junior tranches

The term 'cash waterfall' specifically describes the method of distributing cash flows to senior and junior tranches within structured finance, which includes instruments like collateralized debt obligations (CDOs). In this context, cash flows generated from the underlying assets are allocated in a specified order of priority. Typically, the cash waterfall structure ensures that payments are first made to senior tranches, which are considered lower risk and usually receive payments before others. Once the senior tranches are fully serviced, remaining cash flows can then be directed to junior or subordinated tranches, which carry a higher risk of loss but also offer the potential for greater returns. This prioritization is crucial in managing credit risk, as it establishes a clear framework for how investors receive their payments based on their tranche’s risk profile. Understanding the cash waterfall is essential for analyzing credit risk in securitization, as it directly affects the security's ratings and the overall risk exposure of different investors involved in the transaction.