Module 5
Structured credit & CLOs
Take hundreds of risky corporate loans, pool them, and sell claims on the cashflows in layers— that's a CLO (collateralized loan obligation). The magic is tranching: the same pool is sliced into a safe top layer and a risky bottom layer.
Cash flows down the stack (the “waterfall”): the AAA tranche gets paid first and takes the lowest yield; the equityat the bottom gets whatever's left — the highest potential return. But losses flow up from the bottom: defaults wipe out the equity first, then the junior tranches, and only reach the AAA after everything below it — often 35% of the whole pool — is gone. That cushion (subordination) is exactly why the top can be rated AAA off a pool of junky loans.
There's a safety valve too: overcollateralization (OC) tests. If the pool deteriorates past a trigger, cash is diverted up to pay down the AAA early — protecting seniors while starving the equity. Set the default and recovery rates and watch it happen.
🎛 CLO waterfall simulator
Pool loss = 8% defaults × (1 − 50% recovery) = 4.0% of the pool (≈ $20M). Losses hit the bottom of the stack first.
Senior — paid first, safest
Equity — first loss
Junior OC coverage test
1.067 vs 1.05 trigger
✓ Passing — cash flows normally down the waterfall
No tranche wiped — everyone gets paid.
The AAA (65% of the deal) only takes a loss after every tranche below it — 35% of the pool — is gone first. That subordination is why it's rated AAA.
Tranching slices one risky loan pool into safe and risky pieces: the equity earns the most but absorbs the first loss; the AAA earns the least but is shielded by everything beneath it. Coverage tests protect seniors by rerouting cash when the pool deteriorates. Simplified model — educational tool, not investment advice.
Things to try
- • Nudge the default rate up. Watch losses eat the equity, then the BB, then climb — the AAA stays untouched until the very end.
- • Drop the recovery rate (what's salvaged from defaults). The same defaults now do far more damage.
- • Push defaults high enough to breach the OC test — see cash divert up to protect the AAA.