What is Credit Enhancement
Credit enhancement is a method whereby a company attempts to improve its debt or credit worthiness.
In securitization, credit enhancement refers to a risk-reduction technique that increases the credit profile of structured financial products or transactions.
BREAKING DOWN Credit Enhancement
Credit enhancement is used to obtain better terms for an outstanding debt. Through credit enhancement, the lender is provided reassurance that the corporate borrower will honor its obligation through additional collateral, insurance or a third-party guarantee. Posting collateral and obtaining external credit enhancement such as a letter of credit are some basic forms of credit enhancement. Firms may also increase cash reserves or take other internal measures to uphold superior solvency ratios.
Credit enhancement reduces the credit risk/default risk of a debt, thereby increasing the overall credit rating and lowering interest rates. For example, an issuer may use credit enhancement to improve the credit rating on its bonds. This can be done by taking a guarantee from a bank that agrees to assure a portion of the repayment of dues, which might increase the rating on the corporate bond, for instance from BBB to AA. The bank guarantee serves as an addition to the bond issue that improves the issue's safety of principal and interest. The issuer benefits since its cost of raising funds decreases with a higher credit rating.
Another way the bond issuer can enhance its credit is by purchasing insurance on the payments to guarantee that interest payments and principal repayments will be made.
Credit Enhancement on Securitized Products
Securitized products derive their value from underlying assets, such as mortgages or credit card receivables. Credit enhancement can be thought of as a kind of financial cushion that allows securities backed by a pool of collateral to absorb losses from defaults on the underlying loans, thus offsetting potential losses. It is a key part of the securitization transaction in structured finance and is important for credit rating agencies when rating a securitization. A few of the different types of credit enhancements that are employed are:
- Subordination or Tranching: Securitized financial products, such as asset-backed securities (ABS), have different classes, or tranches, of securities with different credit ratings to appeal to different market segments. The different credit ratings are achieved with credit enhancements, which provide different levels of claims against the cash flow and principal of underlying assets. The tranches are categorized from the most senior to the most subordinated (or junior); the tranche with the highest seniority has the first right to cash flow. If a loan in the pool defaults, any loss incurred is absorbed by the subordinated securities. The subordinated tranches are, therefore, perceived to carry greater risk and pay higher yields.
- Surety Bonds: These are bonds or insurance policies provided by a regulated insurance company to reimburse the asset-backed security for any losses incurred. ABS paired with surety bonds have ratings that are the same as those of the surety bond’s issuer.
- Letter of Credit: For a fee, a bank issues a letter of credit as a promise to pay or reimburse the issuer for any cash shortfalls from the collateral, up to the required credit-enhancement amount.
- Wrapped Securities: A third-party, such as an insurance company, insures the security against any losses by paying back a certain amount of interest or principal on a loan or by buying back some defaulted loans in the portfolio of the investor.
- Overcollateralization: With this credit enhancement, the face value of the underlying loan portfolio is larger than the security it backs, so the issued security is overcollateralized. Even if some of the payments from the underlying loans are late or in default, principal and interest payments on the asset-backed security can still be made.
Other forms of credit enhancements include excess spread, cash collateral account, collateral invested amount, and reserve funds.