How does the securitization waterfall work? I need to understand the cash flow priority structure.

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AcadiFi · Accepted Answer

Securitization creates a special purpose vehicle (SPV) that buys a pool of assets (mortgages, auto loans, credit card receivables) and issues bonds (tranches) backed by those cash flows. The **waterfall** determines the priority of payments. ```mermaid graph TD A[Underlying Asset Pool
e.g., 5000 Mortgages
Total: $500M] --> B[Monthly Cash Flows
Principal + Interest] B --> C[Servicing Fees
0.25% annually] C --> D[Senior Tranche AAA
$350M - 70%
Paid First] D --> E[Mezzanine Tranche BBB
$100M - 20%
Paid Second] E --> F[Equity Tranche NR
$50M - 10%
Paid Last / First Loss] F --> G[Excess Spread
Residual to Equity Holders] H[Defaults / Losses] --> |Absorbed First| F H --> |If Equity Exhausted| E H --> |If Mezz Exhausted| D style D fill:#2d6a4f,color:#fff style E fill:#c9a84c,color:#000 style F fill:#7f1d1d,color:#fff ``` **How the Waterfall Operates — Worked Example:** Pinehurst Capital creates an MBS from a $500M pool of residential mortgages: | Tranche | Rating | Amount | Coupon | Priority | |---|---|---|---|---| | Class A (Senior) | AAA | $350M (70%) | 4.5% | First | | Class B (Mezzanine) | BBB | $100M (20%) | 6.2% | Second | | Class C (Equity) | NR | $50M (10%) | Residual | Last | **Normal Month (no defaults):** The pool generates $3.2M in interest and $1.8M in scheduled principal. 1. **Servicing fee:** 0.25%/12 x $500M = $104K taken off the top. 2. **Senior tranche interest:** $350M x 4.5%/12 = $1.3125M paid next. 3. **Mezzanine tranche interest:** $100M x 6.2%/12 = $516.7K paid next. 4. **Principal:** $1.8M in scheduled principal goes to the senior tranche first (sequential pay). Once Class A is fully retired, principal flows to Class B, then Class C. 5. **Residual:** Any remaining cash flow after all obligations goes to the equity tranche. **Default Scenario:** Suppose $8M of mortgages default with 40% recovery, creating a $4.8M loss. 1. The $4.8M loss hits the **equity tranche first**. Its balance drops from $50M to $45.2M. 2. If cumulative losses exceed $50M, the mezzanine tranche starts absorbing losses. 3. The senior tranche is protected until both subordinate tranches are wiped out — this is called **credit enhancement through subordination**. **Key Concepts for the Exam:** **Credit Enhancement Types:** - **Internal:** Subordination (waterfall structure), overcollateralization (pool > bonds issued), excess spread (weighted average coupon on pool > coupon paid to tranches) - **External:** Third-party guarantees, letters of credit, surety bonds **Prepayment Risk:** When mortgagors refinance or sell homes, principal is returned early. In a sequential-pay structure, prepayments go to the senior tranche first, which shortens its average life. This is **contraction risk** (rates fall, prepayments rise, duration shortens). The opposite is **extension risk** (rates rise, prepayments slow, duration extends). **PAC Tranches** (Planned Amortization Class) are designed to maintain a stable average life by redirecting prepayment variability to a companion (support) tranche. **Exam Tip:** Questions often give you a waterfall and ask what happens to each tranche under different default or prepayment scenarios. Map the cash flows step by step — don't skip levels. Practice structured finance scenarios in our CFA Level II Fixed Income question bank.

How does the securitization waterfall work? I need to understand the cash flow priority structure.

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