IC/OC test

http://accruedint.blogspot.com/2007/03/how-does-cdo-work.html<br /><br />First, there are usually two coverage tests which CDO's calculate: interest coverage (IC) and overcollateralization (OC). The IC test has the total interest earned in the numerator, and the total interest cost of a given tranche and all tranches senior as the denominator plus fees. So in our case, the IC on Class B at the onset of the deal would be $7/($0.58+$4.13+$0.25)=141%. Some trigger is set for how high that number needs to be for each tranche and if the actual number is lower than the trigger, some remedy is required. For example, it might be that money that would have gone to the equity is used to pay down some of the debt tranches. Since the size of the collateral portfolio is the same but the size of the debt is lower, the IC calculation improves.<br /><br />The OC test is similar, except the numerator is the principal value of the portfolio and the denominator is the outstanding amount of a given tranche and all bonds senior. So for Class B at the outset, the OC test would be $100/($75+$10)=118%. Here again, some trigger level is established when the deal is sold, and if the OC falls below that trigger, some remedy is required.<br /><br />The triggers are usually higher for more senior tranches. So the top tranches aren't just protected by the extra cash flow of the deal, but also by the fact that if anything starts to go wrong, cash flow will be diverted from other tranches. The trigger levels also tend to be higher in deals with riskier collateral. A deal with all BB-rated bank loans will have higher IC and OC tests compared with an investment grade resi ABS deal.