LO 35.5: Describe and assess the various types o f credit enhancements.

LO 35.5: Describe and assess the various types o f credit enhancements.
Credit enhancements play an important role in the securitization process by improving the credit rating for the asset-backed security (ABS) or mortgage-backed security (MBS) tranches. The benefits of improved credit quality are even greater for the lowest- rated assets. The different types of credit enhancements used in securitization include: overcollateralization, pool insurance, subordinating note classes, margin step-up, and excess spread.
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Topic 35 Cross Reference to GARP Assigned Reading – Choudhry, Chapter 12
The first two types of credit enhancements are designed to increase the ability of collateral to absorb losses associated with defaults in the underlying asset pool. The lowest class of notes often exhibit overcollateralization where the principal value of the notes issued are valued less than the principal value of the original underlying assets. The additional collateral of the ABS issues absorbs initial losses with no impact to investors. The credit rating can also be enhanced by offering pool insurance. A composite insurance company provides pool insurance on the ABS issues that covers the loss of principal in the collateral pool in the event an SPV defaults.
Other types of credit enhancements are designed to control the cash flows from the collateral pool. Subordinating note classes of a collateral pool into different tranches is another type of credit enhancement. Junior or class B notes are subordinate to more senior class A notes. Therefore, investors in class B do not receive payments of principal until the class A notes are fully redeemed or until rating agency requirements are met. The collateral pool is required to pass certain performance tests over a period of time before making principal payments on subordinate notes.
Two other cash flow related credit enhancements are margin step-up and excess spread. ABS issues sometimes use a margin step-up that increases the coupon structure after a call date. The issuer has the option to redeem the notes after this call date. The margin step-up provides investors with an extra incentive to invest in the issues. However, the issuer may refinance if the increased coupons are greater than market rates.
The excess spread is the difference between the cash inflows from the underlying assets and the cash outflows in the form of interest payments on the ABS issues. The securitization is structured such that the liability side of the SPV (issued notes) has a lower cost than the asset side of the SPV (receivables from mortgages, loans, or credit card debt). After administration expenses are covered, any remaining excess spread is held in a reserve account to protect against future losses. If there are no future losses, the remaining excess spread is returned to the originator.
P e r f o r m a n c e M e a s u r e s f o r S e c u r i t i z e d S t r u c t u r e s