Excess spread is a key concept in consumer finance, specifically when looking at warehouse facilities and asset-backed securitizations. At a high level, excess spread represents the difference between the income generated by the underlying loan assets (consumer loans) and the costs associated with the facility or securitization.
More specifically, excess spread is calculated as:
Excess Spread =
Weighted Average Interest Rate of Loan Assets – (Cost of Financing + Servicing Fees + Credit Losses)
The key components that go into calculating excess spread are:
Weighted Average Interest Rate of Loan Assets
This represents the weighted average annual percentage rate (APR) of the portfolio of consumer loans. This serves as the income generated by the assets.
Cost of Financing
The cost of financing represents the interest expenses and costs paid to fund the loans and finance the portfolio. This includes interest rates paid to warehouse lenders in a warehouse facility or bond coupon rates paid in a securitization.
Servicing Fees
Servicing fees represent the fees paid to a third-party servicer to manage the loan portfolio, including collecting payments, client service, and more. This is usually calculated as a percentage of the outstanding loan principal balance.
Credit Losses
Credit losses refer to the amount of principal lost due to consumer defaults and charge-offs. This adjusts the income for non-performing or charged-off loans.
By subtracting these costs from the weighted average loan interest rate, excess spread demonstrates the net margin or return generated by the loan assets after accounting for financing, servicing, and losses.
Key Uses of Excess Spread
Excess spread serves several key functions in facilities and securitizations:
1. Measures Portfolio Profitability
First and foremost, excess spread demonstrates the profitability and return profile of the underlying consumer loan assets. By quickly showing the net return after all costs, it allows stakeholders to evaluate the attractiveness and viability of the assets.
2. Determines Available Cash for Payments
In both warehouse facilities and securitizations, excess spread plays a key role in the waterfall payment structure which dictates where cash is distributed on a periodic basis. Excess spread is usually used to cover senior fees and payments before junior stakeholders receive any cash.
3. Credit Enhancement in Securitizations
In securitizations, a key risk mitigation feature is the excess spread which can absorb losses before bondholders take any hits. The excess spread sits in the waterfall as the first loss position, providing credit enhancement to bonds and representing a cushion protecting bond investors.
4. Covenant Calculations
In warehouse lines, excess spread thresholds often represent key performance covenants which allow for Toggle Events or Amortization Events if certain excess spread levels dip too low. This protects the warehouse lender.
Average Excess Spread by Loan Product
Since excess spread evaluates portfolio profitability, spreads tend to differ meaningfully depending on the underlying loan product and associated risk and return profile. Below are average excess spread ranges across several core consumer lending verticals:
| Loan Product | Typical Excess Spread Range |
|---|---|
| Prime Unsecured Personal Loans | 6% – 10% |
| Near Prime Unsecured Personal Loans | 8%-14% |
| Subprime Unsecured Personal Loans | 15%-25% |
| Prime Credit Cards | 4%-8% |
| Subprime Credit Cards | 15%-25% |
| Prime Auto Loans | 2%-5% |
| Non-Prime Auto Loans | 5%-15% |
As you move down the credit spectrum from prime into near prime and subprime markets, excess spreads tend to increase as lenders price for higher loss expectations. Additionally, products like credit cards and personal loans generate higher spreads than auto loans given the mix of convenience users in credit cards and high return rates possible with unsecured personal loans.
Conclusion
In summary, excess spread demonstrates the core portfolio return profile net of costs. For warehouse lenders, it represents a key covenant and performance metric. For securitizations, it offers both a credit protection cushion and a key input for investor bond analysis using months of excess spread targets relative to charge-offs.