What is meant by a cash flow waterfall?

Question

What will be an ideal response?

Answer 1

Most securitization transactions that employ internal credit enhancements follow a predetermined schedule that prioritizes the manner in which principal and interest generated by the underlying collateral must be used. This schedule, which is explained in the deal's prospectus, is known as the cash flow waterfall, or simply the waterfall.

At the top of the waterfall would be cash flows due to senior bondholders (interest and principal, depending upon the principal repayment schedule) as well as some standard fees and expenses (e.g., administration and servicing fee). After the cash flow obligations at the top of the waterfall are met, cash flows down to lower priority classes (those rated AA, A, BBB bond classes and so on). The cash flows associated with the excess spread are all that remain after the scheduled periodic payment obligations are met. The excess spread is the first line of defense against collateral losses, because deals that are structured to have a large amount of excess spread can absorb relatively large levels of collateral losses. If the excess spread is fully eaten away by losses, the next lowest-rated class will begin to be negatively affected by credit losses.