Credit Enhancement

 

 

Credit enhancement is a financial process of reducing the credit risk. It is done by offering collateral, insurance or other agreements to the lenders as reassurance if the borrowers fail to pay them back. Through credit enhancement, borrowing concludes at lower rates.[br]

Types of Credit Enhancement

Different situations require different kind of credit enhancement. The techniques can vary from excess spread to cash collateral accounts. On a macro level, they can be categorized as internal credit enhancement techniques and external credit enhancement techniques

 

Let us look at some internal techniques briefly:

• Excess spread: The remaining net interest amount from the underlying assets of any asset backed security (ABS). The net amount is deposited with the banks, or given out to the investors for enhancing credit.

• Over-collateralization: In this style of credit enhancement, the underlying assets face value exceeds the face value of the security issued. For example, the principal amount of an issue may be just $100 million, whereas the asset’s value may be around $120 million.

• Reserve account: This kind of account assures the lenders of a certain amount of reimbursement in case the borrowers default. The account is non-declining, which means that the amount keeps on increasing till the total outstanding is paid off.[br] 

Next, we shall look at some external techniques:

 

• Surety bond: These bonds are reimbursed in case of any loses in the asset backed securities. These bonds deliver credit enhancement, which matches with the surety bond’s issuers.

• Wrapped securities: A security that is guaranteed, or insured by a third party, is a wrapped security. The third party could be the parent company of the security issuer and may include buying back the default loans.

• Letter of credit: It is an irrevocable promise to pay the lenders a specified amount. However, usage of LOC is on a decline as rating agencies degraded the long-term debt with LOC in the early 1990’s.

• Cash collateral account: This way of credit enhancement works when the issuer borrows the required amount from a bank and deposits the money with a short-term commercial paper.

 

Cash collateral accounts do not degrade as they are actual deposit of money. However, the most common credit enhancement technique remains the excess spread and over collateralization.