Credit enhancement
Encyclopedia
Credit enhancement is a key part of the securitization transaction in structured finance
, and is important for credit rating agencies
when rating a securitization
. The credit crisis of 2007-2008 has discredited the process of credit enhancement of structured securities as a financial practice as the risk was not assessed correctly and defaults began to rise. If the credit rating was properly assessed and higher interest rates assigned to structured securities, then the crisis may have been averted.
This structural protection is called the waterfall structure. The priority for the cash flows comes from the top, while the distribution of the losses rises from the bottom.
If an asset in the pool defaults, losses thus incurred are allocated bottom up (from the most junior to the most senior tranche).
The senior tranche is unaffected unless losses exceed the amount of the subordinated tranches, and is usually rated AAA.
(ABS) can still be made.
s are insurance policies that reimburse the ABS for any losses. They are external forms of credit enhancement. ABS paired with surety bonds have ratings that are the same as that of the surety bond’s issuer. By law, surety companies cannot provide a bond as a form of a credit enhancement guarantee.
(LOC), a financial institution — usually a bank — is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount. Letters of credit are becoming less common forms of credit enhancement, as much of their appeal was lost when the rating agencies downgraded the long-term debt of several LOC-provider banks in the early 1990s. Because securities enhanced with LOCs from these lenders faced possible downgrades as well, issuers began to utilize cash collateral accounts instead of LOCs in cases where external credit support was needed.
Structured finance
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid lawsStructured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws...
, and is important for credit rating agencies
Credit rating agency
A Credit rating agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves...
when rating a securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
. The credit crisis of 2007-2008 has discredited the process of credit enhancement of structured securities as a financial practice as the risk was not assessed correctly and defaults began to rise. If the credit rating was properly assessed and higher interest rates assigned to structured securities, then the crisis may have been averted.
Subordination or credit tranching
Senior/Subordinated structures are the most popular technique to create internal credit enhancement. The cash flows generated by the assets are allocated with different priority to classes of different seniority. The senior/subordinated structure thus consists of several tranches, from the most senior to the most subordinated (or junior). The subordinated tranches function as protective layers of the more senior tranches. The class of highest seniority has first right on the available principal cash flows.This structural protection is called the waterfall structure. The priority for the cash flows comes from the top, while the distribution of the losses rises from the bottom.
If an asset in the pool defaults, losses thus incurred are allocated bottom up (from the most junior to the most senior tranche).
The senior tranche is unaffected unless losses exceed the amount of the subordinated tranches, and is usually rated AAA.
Excess spread
The excess spread is the difference between the interest rate received on the underlying collateral and the coupon on the issued security. It is typically one of the first defenses against loss. Even if some of the underlying loan payments are late or default, the coupon payment can still be made. In the process of "turboing", excess spread is applied to outstanding classes as principal.Overcollateralization
Overcollateralization (OC) is a commonly used form of credit enhancement. With this support structure, the face value of the underlying loan portfolio is larger than the security it backs, thus the issued security is overcollateralized. In this manner, even if some of the payments from the underlying loans are late or default, principal and interest payments on the asset-backed securityAsset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
(ABS) can still be made.
Reserve account
A reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the reserve. To increase credit support, the reserve account will often be non-declining throughout the life of the security, meaning that the account will increase proportionally up to some specified level as the outstanding debt is paid off.Surety bonds
Surety bondSurety bond
A surety bond is a promise to pay one party a certain amount if a second party fails to meet some obligation, such as fulfilling the terms of a contract...
s are insurance policies that reimburse the ABS for any losses. They are external forms of credit enhancement. ABS paired with surety bonds have ratings that are the same as that of the surety bond’s issuer. By law, surety companies cannot provide a bond as a form of a credit enhancement guarantee.
Wrapped securities
A wrapped security is insured or guaranteed by a third party. A third party or, in some cases, the parent company of the ABS issuer may provide a promise to reimburse the trust for losses up to a specified amount. Deals can also include agreements to advance principal and interest or to buy back any defaulted loans. The third-party guarantees are typically provided by AAA-rated financial guarantors or monoline insurance companies.Letter of credit
With a letter of creditLetter of credit
A standard, commercial letter of credit is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking....
(LOC), a financial institution — usually a bank — is paid a fee to provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount. Letters of credit are becoming less common forms of credit enhancement, as much of their appeal was lost when the rating agencies downgraded the long-term debt of several LOC-provider banks in the early 1990s. Because securities enhanced with LOCs from these lenders faced possible downgrades as well, issuers began to utilize cash collateral accounts instead of LOCs in cases where external credit support was needed.
Cash collateral account
With a cash collateral account (CCA), credit enhancement is achieved when the issuer borrows the required credit support amount from a commercial bank and then deposits this cash in short-term commercial paper that has the highest available credit quality. Because a CCA is an actual deposit of cash, a downgrade of the CCA provider would not result in a similar downgrade of the security.See also
- Pooled investment
- PrivatizationPrivatizationPrivatization is the incidence or process of transferring ownership of a business, enterprise, agency or public service from the public sector to the private sector or to private non-profit organizations...
- Senior stretch loanSenior stretch loanA senior stretch loan, or overadvance loan, is a hybrid debt instrument consisting of both asset-based loan and cash flow loan. Such loans are suitable for two types of companies:...
- Thomson Financial League Tables