Introduction to Securitization

ASSET AND INCOME COVERAGE TESTS

We have referred to the OC and IC triggers several times in the preceding two chapters. The intuitive idea of the OC and IC trigger goes to the very root of commercial finance. For example, a bank giving a loan on a project would try to ensure a certain asset coverage or debt/ equity ratio, and debt service coverage. Likewise, a CDO is allowed to maintain a certain leverage only as long as the OC and IC tests are satisfied. If the CDO manager continues to reinvest the cash flows of the CDO and maintains the liability structure, he is maintaining the leverage of the transaction. On the other hand, if the manager uses the cash flows to retire senior investors sequentially, he is reducing the leverage of the transaction, or deleveraging the transaction. Hence, the OC and IC triggers serve as automatic deleverage triggers in the CDO.⁶¹

These are the tests that require regular adherence over the term of the CDO. As discussed below, there are two significant coverage tests, both in respect of the rated securities.

Overcollateralization Test

Since the liability structure of a CDO, like any structured finance vehicle, has various classes, the total amount of assets available to the seniormost class is in excess of the liability for the seniormost class. For example, if the assets in a pool are $100, and the seniormost class is $80, there is an overcollateralization of $20 if the seniormost class is looked at in isolation. The extent of overcollateralization ...