Credit Enhancement
AdvancedCredit enhancement is any feature that reduces the credit risk of a security, especially in a securitization, making it more likely that investors will be repaid and often allowing it to receive a higher credit rating.
Securities backed by pools of loans can be made safer for investors in several ways. Internal credit enhancement is built into the structure. External credit enhancement comes from a third party.
Common internal forms include subordination, where junior tranches absorb losses before senior ones; overcollateralization, where the value of the underlying assets exceeds the value of the securities issued; excess spread, where interest from the loans exceeds interest paid to investors, providing a cushion; and reserve accounts set aside to cover shortfalls.
For example, if loans worth 100,000,000 back notes worth 90,000,000, the 10,000,000 of overcollateralization provides a buffer against defaults before noteholders suffer losses.
External forms include guarantees, letters of credit and insurance from financial guarantee companies, sometimes called bond insurers. Before 2008, some bond insurers guaranteed large amounts of mortgage-related securities, and their financial problems during the crisis showed that external enhancement is only as strong as the provider.
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