A securitised personal loan pool yields 14% a year. Investors are paid 8.5%, servicing costs 1% and expected losses are 3%. What is the excess spread, how does it protect investors, and what happens if losses rise to 5%?

Excess spread is 1.5% a year, about Rs 7.5 crore on a Rs 500 crore pool. It is the 14% yield less 8.5% to investors, 1% servicing and 3% expected losses, and it absorbs any loss above expectations before investors feel it. If losses reach 5%, it turns to minus 0.5%: the first line of defence is gone and the Rs 25 crore reserve starts paying about Rs 2.5 crore a year.

A household earns Rs 14,000 a month, pays Rs 8,500 of rent, Rs 1,000 of fixed bills and usually spends Rs 3,000 on things that go wrong. The Rs 1,500 left over is its buffer: if repairs cost more one month, that is what pays. Excess spread is the pool's leftover income after paying investors, the servicer and the expected losses, and it is the first money used to absorb losses above expectations. For Tavrisa's pool that is 14 - 8.5 - 1 - 3, which is 1.5%, or Rs 7.5 crore a year.

Losses are met first from the current year's income, then from the reserve, then from any subordinated notes, and only then from senior investors. Because excess spread sits at the top of that order, losses can rise from 3% to 4.5% of the pool a year before the reserve is touched. Rating agencies credit it, but carefully, because it is income that may not arrive rather than cash already in the deal. That is also why most deals trap excess spread in the reserve when performance slips, instead of releasing it to the originator.

At 5% losses excess spread is -0.5%, a Rs 2.5 crore annual shortfall. The Rs 25 crore reserve would last about 10 years at that pace, so investors are still paid. The deeper problem is that excess spread shrinks from two sides at once: the loans that default are often the highest-rate ones, and borrowers with good credit prepay and refinance elsewhere, so the pool's 14% yield drifts down just as losses rise. A 5% loss year with the yield down to 13% leaves a 1.5% hole, three times the shortfall above. That is why excess spread is called the first line of defence and the first to disappear.

Close with what you would check in the deal documents: whether excess spread is trapped when losses cross a trigger, how the reserve is replenished, and whether the servicing fee is senior to investors. Each changes how long investors stay protected, and each is a line a rating analyst reads before trusting the 1.5%.