Overcollateralization (OC) is an important concept in structured finance, especially in collateralized loan obligations (CLOs) and other asset-backed securities.
For CLOs and debt warehouse facilities, overcollateralization provides extra protection for investors by providing a cushion in case some loans default or lose value. Having excess collateral means payments to investors should not be interrupted even if some assets underperform.
How Overcollateralization is Calculated
Overcollateralization is calculated by comparing the value of the collateral assets in a portfolio to the outstanding debts or securities. For example:
- Collateral Assets Value: $100 million
- Debts/Securities Outstanding: $80 million
- Overcollateralization: $100 million / $80 million = 125%
In this example, the collateral assets are equal to 125% of the debts owed to investors. This 25% extra cushion provides overcollateralization.
CLO managers and other asset-backed securities follow certain OC tests to ensure enough protection throughout the life of the securities. These tests establish minimum OC levels and are defined in the offering documents for each deal.
Overcollateralization by Loan Type
Required overcollateralization levels can vary based on the underlying loan assets in each warehouse facility or CLO. Facilities with higher risk loans generally need higher OC for the same rating level compared to lower risk collateral.
Broadly Syndicated Loans
Broadly syndicated loans (BSLs) are made to larger, more established corporate borrowers. They are more standardized and liquid than middle market or distressed loans. As such, lenders can rely on lower OC requirements for facilities containing these assets.
Typical OC levels for CLOs with 90%+ broadly syndicated loans:
- AAA-rated: 128%
- AA-rated: 122%
- A-rated: 117%
Middle Market Loans
Middle market loans have higher default rates and lower liquidity compared to broadly syndicated loans. They are made to small and medium enterprises compared to large corporate borrowers. To compensate for the higher risks, lenders require higher overcollateralization on facilities with these loans.
Typical OC levels for CLOs with 90%+ middle market loans:
- AAA-rated: 138%
- AA-rated: 130%
- A-rated: 122%
Distressed Loans
Distressed loans are made to borrowers that already have financial difficulties or a high risk of default. They trade at a discount to par value and lenders demand even higher overcollateralization for portfolios containing these assets.
Typical OC levels for distressed loan CLOs across ratings levels:
- AAA-rated: 148%
- AA-rated: 142%
- A-rated: 135%
The higher OC provides additional protection against the increased chance of interruptions in interest payments or loss of principal on distressed assets.
Overcollateralization and CLO Ratings
Overcollateralization is an important credit enhancement for CLO tranches to achieve certain ratings from agencies like S&P and Moody’s. Along with subordination, OC provides protection for senior note holders against potential losses in the underlying loan portfolio.
Higher overcollateralization generally allows CLO tranches to obtain higher credit ratings with all else being equal. By improving credit subordination, structural protections, and overall loss cushions, overcollateralization makes senior notes less risky in the eyes of ratings agencies.
For example, a CLO note with a 125% overcollateralization ratio could potentially get an AAA rating, while a similar note with only 118% OC might only reach an A rating. The extra 7% cushion significantly improves ratings outcomes for senior note holders.
CLO OC Tests Through Lifetime
Most CLOs have two main OC tests that need to be satisfied at all times after the closing date:
Class A/B OC Test
The Class A/B overcollateralization test requires a certain minimum level of OC based on the original ratings of the CLO’s class A and B tranches. This helps ensure enough subordination for class A and B note holders throughout the deal.
For example, if the Class A notes originally obtained a AAA rating and Class B obtained a AA rating, the deal documents would require 122% minimum OC by this test. That matches a typical AAA/AA OC ratio as described earlier.
Class C OC Test
This test establishes a minimum OC level relative to the outstanding balance of the CLO’s class C tranches. It provides extra subordination protection for the class C notes.
For example, the Class C OC test could require 115% minimum overcollateralization as long as Class C notes are outstanding. That means the collateral assets must equal at least 115% of the class A, B, and C notes combined.
Failing OC tests can divert cash flows toward repaying senior notes quicker to restore OC cushions. More drastic outcomes like early liquidation of collateral can result in extreme OC test failures. CLO managers are strongly incentivized to maintain healthy overcollateralization to avoid these scenarios.
Overcollateralization Build-Up
Many CLOs deploy an “OC builder” feature that helps provide protection against market value declines in underlying loans after the closing date.
Essentially, this feature traps excess spread cash flows instead of paying them out to equity holders right away. The trapped cash builds up over time and adds to the OC cushion in the deal.
For example, say a CLO has $100 million of loans generating $3 million of annual excess spread (income left over after paying coupons and fees). With an OC builder, that $3 million could be trapped and added to OC each year rather than paid immediately to equity.
After 3 years the CLO’s par value would still be $100 million. But the trapped excess cash would now boost the market value of collateral assets to $109 million. This improves minimum OC ratios and ratings safety for senior notes despite any reduction in market values of the original loan pool.
The OC builder helps ensure senior tranches maintain healthy overcollateralization cushions over the full lifetime of a transaction.
Conclusion
Overcollateralization is core to the structure and function of CLO tranches and debt warehouse financing facilities. By providing excess collateral coverage relative to debt obligations, overcollateralization gives investors an added layer of protection against interruptions in payments or losses in market value.
Higher overcollateralization ratios allow senior tranches to achieve better ratings from agencies like S&P and Moody’s. OC requirements in CLOs are structured based on the riskiness profiles of underlying assets—with distressed loans needing bigger cushions compared to broadly syndicated loans.