Credit enhancement

Last updated
Borrowing under a securitization structure Borrowing Under a Securitization Structure.png
Borrowing under a securitization structure

Credit enhancement is the improvement of the credit profile of a structured financial transaction or the methods used to improve the credit profiles of such products or transactions. It is a key part of the securitization transaction in structured finance, and is important for credit rating agencies when rating a securitization.

Structured finance

Structured finance is a sector of finance, specifically Financial law that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.

Credit rating agency company that assigns credit ratings

A credit rating agency is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and in some cases, of the servicers of the underlying debt, but not of individual consumers.

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 their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Contents

Types

There are two primary types of credit enhancement: internal and external.

Internal credit enhancement

Subordination or credit tranching

Establishing a senior/subordinated structure is one of the most popular techniques to create internal credit enhancement. Cash flows generated by assets are allocated with different priorities to classes of varying seniorities. 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 tranche with the highest seniority has the first right on cash flow.

Such protection comes under a waterfall structure. Priority for cash flow comes from the top, while distribution of losses rises from the bottom. If an asset in the pool defaults, the losses thus incurred are allocated from the bottom up (from the most junior to the most senior tranche). The senior tranche (often rated AAA) is unaffected, unless the amount of the losses exceeds the amount in the subordinated tranches.

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. [1]

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 ABS (asset-backed security) can still be made. [1]

Asset-backed security Security with value derived from a commodity or asset

An asset-backed security (ABS) is a security whose income payments and hence value 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 which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.

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. [1]

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. [1] By law, surety companies cannot provide a bond as a form of a credit enhancement guarantee.

A surety bond or surety is a promise by a surety or guarantor to pay one party a certain amount if a second party fails to meet some obligation, such as fulfilling the terms of a contract. The surety bond protects the obligee against losses resulting from the principal's failure to meet the obligation.

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. [1]

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. [1]

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. [1]

See also

Related Research Articles

Derivative (finance) financial instrument whose value is based on one or more underlying assets

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying." Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

Collateralized mortgage obligation

A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor needs.

Collateralized debt obligation financial product

A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a PD derived from ratings on those bonds or assets. The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA ; Junior AAA; AA; A; BBB; Residual.

Commercial mortgage-backed security

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential real estate. CMBS tend to be more complex and volatile than residential mortgage-backed securities due to the unique nature of the underlying property assets.

Single-tranche CDO or bespoke CDO is an extension of full capital structure synthetic CDO deals, which are a form of collateralized debt obligation. These are bespoke transactions where the bank and the investor work closely to achieve a specific target.

Residential mortgage-backed security

Bonds securitizing mortgages are usually treated as a separate class, termed residential mortgage-backed security (RMBS). In that sense, making reference to the general package of financial agreements that typically represents cash yields that are paid to investors and that are supported by cash payments received from homeowners who pay interest and principal according to terms agreed to with their lenders; it is a funding instrument created by the "originator" or "sponsor" of the mortgage loan; without cross-collateralizing individual loans and mortgages, it is a funding instrument that pools the cash flow received from individuals and pays these cash receipts out with waterfall priorities that enable investors to become comfortable with the certainty of receipt of cash at any point in time.

Bond insurance is a type of insurance whereby an insurance company guarantees scheduled payments of interest and principal on a bond or other security in the event of a payment default by the issuer of the bond or security. As compensation for its insurance, the insurer is paid a premium by the issuer or owner of the security to be insured. Bond insurance is a form of "credit enhancement" that generally results in the rating of the insured security being the higher of (i) the claims-paying rating of the insurer and (ii) the rating the bond would have without insurance.

Appraisal Subordination Entitlement Reduction (ASER) or collateral valuation adjustments (CVA) are commercial mortgage-backed security (CMBS) structuring innovations designed to improve overall transaction credit quality. Appraisal Reductions were created in response to rating agency concerns that, without such an adjustment, cash flow from mortgages likely to default would be paid to the first-loss class. The rationale behind appraisal reductions is to support proactively the credit rating of senior CMBS tranches by reducing cash-flow payments to the subordinate tranches.

Collateral valuation adjustment (ColVA) or appraisal subordination entitlement reduction (ASER) are commercial mortgage-backed security structuring innovations designed to improve overall transaction credit quality. Collateral valuation adjustments were created in response to rating agency concerns that, without such an adjustment, cash flow from mortgage loans likely to default would be paid to the first-loss class. The rationale behind appraisal reductions is to support proactively the credit rating of senior CMBS tranches by reducing cash-flow payments to the subordinate tranches.

Collateralized loan obligation

Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation.

A synthetic CDO is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments — as in the case of a regular or "cash" CDO — but from premiums paying for credit default swap "insurance" on the possibility that some defined set of "reference" securities — based on cash assets — will default. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

Credit rating agencies (CRAs)—firms which rate debt instruments/securities according to the debtor's ability to pay lenders back—played a significant role at various stages in the American subprime mortgage crisis of 2007–2008 that led to the great recession of 2008–2009. The new, complex securities of "structured finance" used to finance subprime mortgages could not have been sold without ratings by the "Big Three" rating agencies—Moody's Investors Service, Standard & Poor's, and Fitch Ratings. A large section of the debt securities market—many money markets and pension funds—were restricted in their bylaws to holding only the safest securities—i.e. securities the rating agencies designated "triple-A". The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007. Hundreds of billions of dollars' worth of these triple-A securities were downgraded to "junk" status by 2010, and the writedowns and losses came to over half a trillion dollars. This led "to the collapse or disappearance" in 2008–09 of three major investment banks, and the federal governments buying of $700 billion of bad debt from distressed financial institutions.

A renewable energy derivative is based on a new method of securitization, which is a structured finance process that pools and repackages cash-flow-producing financial assets into securities which are then sold to investors. The term "securitization" is derived from the fact that securities are used to obtain funds from investors.

Tranche Part of an investment

The word tranche is French for 'slice', 'section', 'series', or 'portion', and is a cognate of the English 'trench' ('ditch'). In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation usually defines the tranches as different "classes" of notes, each identified by letter with different bond credit ratings.

References

  1. 1 2 3 4 5 6 7 Fixed Income Sectors: Asset-Backed Securities A primer on asset-backed securities, Dwight Asset Management Company 2005