What it means
Think of one pot of money collected in a month, such as loan repayments from thousands of borrowers. The waterfall payment is the rulebook for emptying that pot.
Fees and costs usually come first, followed by interest to the most senior lenders, then interest to junior lenders, then repayment of principal, and finally whatever is left for the owners of the equity. The sequence is set in the legal documents of the deal and followed mechanically by a trustee or administrator (the party who manages payments on behalf of investors).
Because the order is written down in advance, nobody can choose who to pay first when cash is tight. This protects senior lenders and is the main reason they accept lower interest rates.
Waterfall payments are central to securitisation, where pools of loans such as car loans or credit card debts are packaged and sold to investors in layers called tranches. Senior tranches are paid first and carry the lowest risk, while junior tranches are paid later and carry the highest.
Each layer is priced to match its position in the order of payment. Cash shortfalls show the structure at work.
If borrowers pay less than expected, the senior tranches are still paid in full while the lower tranches absorb the shortage. Credit rating agencies look at the waterfall closely because it shows how many losses the pool can suffer before each layer is hit.
A common nuance is that waterfalls can change when trouble arises. Many deals have triggers, such as a high level of defaults, that switch the payment order so that cash is diverted to repay senior debt faster.
Anyone reading a deal document should check for these triggers, as they change the timing of cash for the lower tranches.
In practice
Real-world examples.
Example
A bank bundles $500,000,000 of car loans into securities with senior and junior layers. Each month the trustee collects repayments and pays them down the layers in the order set out in the documents. Senior investors are always paid before the junior layer receives any cash.
Example
A property developer borrows from a senior bank and a junior investor to fund an apartment project. Sales proceeds of $9,000,000 are paid first to cover sales costs, then the bank's loan and interest, then the junior investor, with any remainder going to the developer. The bank's lower risk is reflected in its lower interest rate.
Example
A company enters liquidation with $3,000,000 of cash from selling its assets. The administrator pays the costs of the process first, then secured creditors, then employees and other priority claims, then unsecured creditors. Shareholders receive money only if everyone above them has been paid in full.
Formula
Calculation
Payment to each tier = Lesser of (Amount due to that tier) and (Cash available after higher tiers)
Suppose a loan pool collects $1,000,000 in a month. The payments are: fees $50,000, senior interest $200,000, junior interest $150,000, senior principal $400,000, and the remainder to equity. Fees are paid first, leaving 1,000,000 - 50,000 = $950,000. Senior interest leaves 950,000 - 200,000 = $750,000, junior interest leaves 750,000 - 150,000 = $600,000, and senior principal leaves 600,000 - 400,000 = $200,000, which goes to equity. Now suppose collections fall to $600,000. Fees and senior interest take 50,000 + 200,000 = $250,000, junior interest takes $150,000 leaving $200,000, and senior principal is only partly paid at $200,000 of the $400,000 due, so equity receives nothing.Case study
Seen in the real world.
Dunmore Auto Receivables is an illustrative, fictional securitisation vehicle that pooled $40,000,000 of consumer car loans. It issued a senior layer of $30,000,000 and a junior layer of $10,000,000, with all payments flowing through a waterfall.
In a bad quarter, higher unemployment caused collections to fall by 15% below expectations. The trustee followed the waterfall, paying fees and senior interest in full, but junior interest was only partly paid that month.
In this illustrative story the senior investors were unaffected and the junior investors received a warning that their layer was at risk. The lesson is that the waterfall does not create cash, it simply decides who bears the shortage.
Watch out
Common mistakes.
- Assuming all investors in a deal are treated equally when a shortage arises, when the waterfall places junior investors behind senior ones.
- Forgetting that fees and expenses usually rank first, which reduces the cash available to investors.
- Reading the payment order from marketing material rather than the legal documents, where the exact sequence and triggers are set out.
Questions
People also ask.
What is a tranche?
A tranche is one layer of a securitised deal, with its own rank in the payment order, risk and interest rate.
What happens if cash is not enough for a tier?
The tier receives what is left and the lower tiers receive nothing, and the unpaid amount may be carried forward or written off depending on the contract.
Can the waterfall change during the life of the deal?
Yes, many deals have triggers, such as rising defaults, that change the order or redirect cash to repay senior debt faster.
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