Credit Enhancement

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          World Of Finance by Vijaya Sai.M
Credit enhancement is a key part of the securitisation transaction in structured finance, and is important for credit rating agencies when rating a securitisation. 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.

Types of Credit Enhancement 

There are two primary types of Credit Enhancement:

1.Internal
2.External.

Internal Credit Enhancement

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 security (ABS) can still be made. In the mortgage market the overcollateralized loans might not work well in case the value of the collateral kept as part of the loan that is the real estate itself starts depreciating in value. This is particularly seen in the developed economies or economies where there is excess supply of the finished products in the form of real estate than the demand for the same. It was observed in the USA in 2007-08 with declining value of the real estate particularly in California and some southern states, where the over collateralization was reversed and the risk passed on to the insurers, guarantors and the re-sellers of the same risk.

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.

External Credit Enhancement

Surety bonds 

Surety bonds 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 mono-online insurance companies.

Letter of credit

With a letter of  credit (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. 

Look  this video to know how banks enhance credit enhancement.

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