The cushion is collateral value, not points, and a defaulted loan uses it up at the haircut rather than at par.
The overcollateralisation test in a CRE CLO divides the collateral balance, with defaulted or impaired loans carried at a haircut value, by the notes outstanding, and diverts interest from the equity to repay the senior notes whenever the ratio falls below its trigger. On an illustrative 1,000 million pool with 800 of notes and a 122.0 per cent trigger, 60.0 of defaulted loans carried at 60 per cent of par trips the test. At 80.0 of defaults the equity loses 6.56 of cash, 1.5 quarters of its distributions.
Worked in full in CMBS and CRE CLOs by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A CRE CLO funds a pool of floating-rate transitional loans with notes sold to investors and a retained equity tranche, usually preferred shares held by the sponsor. The overcollateralisation test protects the notes: if collateral value falls relative to the notes, cash that would have gone to the equity is used to repay the most senior notes until the ratio is restored. The case below is illustrative, with a single OC test measured at the most junior class of notes.
| Input | Value |
|---|---|
| Collateral pool, par | 1,000.0 |
| Notes outstanding, all classes | 800.0 |
| Retained equity | 200.0 |
| Advance rate | 80.0% |
| OC trigger | 122.0% |
| Defaulted loans carried at, share of par | 60% |
| Reference rate | 4.00% |
| Loan spread, weighted average | 3.40% |
| Note spread, weighted average | 1.95% |
| Senior fees and expenses, a year | 3.0 |
OC ratio = (performing par + defaulted par × carrying value) / notes outstanding
At closing: 1,000.0 / 800.0 = 125.0%, a cushion of 3.0 points over the trigger
Minimum collateral = 122.0% × 800.0 = 976.0, so the cushion is 24.0 of collateral value
Default par that trips the test = 24.0 / 40% haircut = 60.0, or 6.0 per cent of the pool
In Excel: =(B2-B12*(1-B7))/B3 for the ratio with B12 the defaulted par, and =(B2-B6*B3)/(1-B7) for the trip point.
The cushion is not 3.0 points of losses; it is 24.0 of collateral value, and a defaulted loan uses it up at the haircut, not at par. With 40 per cent written off on the test, each 10 of defaults consumes 4 of cushion. A pool can therefore absorb 6.0 per cent of defaults before the equity is cut off, but only 2.4 per cent of the pool written off on the test.
Two loans totalling 80.0 default. They are carried at 48.0 on the test, the adjusted collateral is 968.0, and the ratio falls to 121.00 per cent. To restore 122.0 per cent the notes must fall to 968.0 / 1.22 = 793.44, a paydown of 6.56.
| Line | Before | After 80.0 of defaults |
|---|---|---|
| Collateral interest at 7.40% | 74.00 | 68.08 |
| Note interest at 5.95% | 47.60 | 47.60 |
| Senior fees | 3.0 | 3.0 |
| Cash available to the equity | 23.40 | 17.48 |
| Per quarter | 5.85 | 4.37 |
The defaulted loans stop paying 5.92 a year of interest, which reduces the equity's cash before the test does anything. The test then takes the next 6.56 entirely: at 4.37 a quarter that is 1.5 quarters with no distribution, after which the ratio is back at 122.00 per cent and cash flows to the equity again, ignoring the small interest saving on the notes repaid. The equity, which earned 11.7 per cent on 200.0 before the defaults, pays twice: once in lost coupon and once in diverted cash.
| Defaulted par | Adjusted collateral | OC ratio | Cushion, points | Paydown needed | Equity cash a quarter | Quarters diverted |
|---|---|---|---|---|---|---|
| 40.0 | 984.0 | 123.00% | 1.00 | 0.00 | 5.11 | 0.0 |
| 60.0 | 976.0 | 122.00% | 0.00 | 0.00 | 4.74 | 0.0 |
| 80.0 | 968.0 | 121.00% | -1.00 | 6.56 | 4.37 | 1.5 |
| 100.0 | 960.0 | 120.00% | -2.00 | 13.11 | 4.00 | 3.3 |
| 150.0 | 940.0 | 117.50% | -4.50 | 29.51 | 3.08 | 9.6 |
The cost to the equity is steeply non-linear. Defaults of 100.0 shut off distributions for over three quarters; 150.0, for more than two years. The haircut matters as much as the default amount: carrying defaulted loans at 70 per cent of par moves the trip point to 80.0 of defaults; at 50 per cent it falls to 48.0, and 80.0 of defaults then needs a 13.11 paydown.
Who sets the carrying value matters. Many CRE CLOs carry a defaulted or credit-risk loan at the lower of its market value and a rating-agency recovery rate, and some let the collateral manager exchange or buy out impaired loans before they hit the test. Read the definition of defaulted obligation and its carrying value before running any number.
Running the test on par. With 80.0 of loans in default, par collateral is still 1,000.0 and the ratio still reads 125.0 per cent, so the model shows the equity paid in full until a loss is actually realised at liquidation, often several quarters later. In the deal, the diversion starts at the next payment date after the loans are classified as defaulted. A cash flow model of the equity that does not haircut impaired loans on the test overstates its near-term distributions exactly in the scenario the test exists for.
Compute the cushion as collateral value, not as points, and divide it by the haircut to find the default par that trips the test: 24.0 over 40 per cent, or 60.0, here. Beyond it, each defaulted loan costs the equity its coupon and then its distributions. The book's CRE CLO workbook runs the retained-equity return by advance rate and the OC test with the haircut as an input, in the free workbook for this book. For why realised losses run above what the appraisal implies, see why realised severity exceeds appraisal severity.
Interest that would have been paid to the equity is diverted to repay the most senior notes until the ratio is back above the trigger. In the illustrative deal, 80.0 of defaults takes the ratio to 121.00 per cent and diverts 6.56, about 1.5 quarters of equity distributions.
They are carried at a reduced value set by the indenture, often the lower of market value and a recovery rate, instead of par. At 60 per cent of par the illustrative test trips at 60.0 of defaults; at 50 per cent it trips at 48.0, and at 70 per cent at 80.0.
Measure it in collateral, not in ratio points: collateral minus trigger times notes. The illustrative 3.0 point cushion is 24.0 of collateral on 800.0 of notes, which is 60.0 of defaults at a 40 per cent haircut, or 6.0 per cent of the pool.
This article is one calculation from CMBS and CRE CLOs. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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