If coverage tests are failed for a CDO, how is the principal received from the collateral used?

Question

What will be an ideal response?

Answer 1

If the coverage tests are failed for a CDO, the principal cash flow is used to pay down tranches in the following order: senior, mezzanine and subordinate/equity. More details are supplied below.

The principal cash flow is distributed as follows after the payment of the fees to the trustees, administrators, and senior managers. If there is a shortfall in interest paid to the senior tranches, principal proceeds are used to make up the shortfall. Assuming that the coverage tests are satisfied during the reinvestment period, the principal is reinvested. After the reinvestment period or if the coverage tests are failed, the principal cash flow is used to pay down the senior tranches until the coverage tests are satisfied. If all the senior tranches are paid down, then the mezzanine tranches are paid off, followed by the subordinate/equity tranche.

After all the debt obligations are satisfied in full, if permissible, the equity investors are paid. Typically, there are also incentive fees paid to management based on performance. Usually
a target return for the equity investors is established at the inception of the transaction. Management is then permitted to share on some prorated basis once the target return is achieved.

Finally, the collateral manager must monitor the collateral to ensure that certain tests are being met. There are two types of tests imposed by rating agencies: quality tests and coverage tests.