Securitisation is a financial process that enables lenders to convert illiquid assets, such as loans or mortgages, into tradable securities. By doing so, it provides an avenue for banks and financial institutions to free up capital, reduce credit risk, and improve liquidity. One crucial aspect of securitisation that bolsters its appeal to investors is credit enhancement. In this post, we will delve into the concept of credit enhancement, its various types, and how it works in a securitisation structure.

Understanding Credit Enhancement

Credit enhancement is a risk-mitigation mechanism employed in securitisation transactions to improve the credit quality of the underlying assets and, consequently, the securities issued. By reducing the risk associated with the securities, credit enhancement can lead to higher credit ratings, lower borrowing costs, and a broader investor base.

Types of Credit Enhancement

Credit enhancements can be broadly categorized into two types: internal and external credit enhancements.

  1. Internal Credit Enhancement

Internal credit enhancements are structural mechanisms built into the securitisation transaction itself. They include:

a. Overcollateralisation: This involves issuing securities with a total face value lower than the aggregate value of the underlying assets. In the event of default or underperformance of some assets, the excess collateral helps to absorb the losses, providing a cushion for investors.

b. Subordination: In a securitisation structure, securities may be divided into tranches with different levels of seniority. Senior tranches have priority in receiving payments from the underlying assets, while subordinate tranches absorb losses first. This structure provides a higher level of protection to senior tranche investors.

c. Excess Spread: This is the difference between the interest received from the underlying assets and the interest paid to investors. The excess spread can be used to cover potential losses or can be set aside as a reserve to cover future losses.

d. Reserve Accounts: A reserve account can be established as part of the securitisation structure to cover potential losses. It can be funded by the excess spread or an initial cash deposit from the issuer.

  1. External Credit Enhancement

External credit enhancements involve third-party guarantees or support to bolster the credit quality of the securitised assets. They include:

a. Surety Bonds: A surety bond is a guarantee provided by an insurance company or another financial institution, promising to cover potential losses up to a certain amount.

b. Letters of Credit: A letter of credit is a guarantee provided by a bank or financial institution, assuring that it will make the required payments if the issuer of the securities fails to do so.

c. Credit Default Swaps: This is a financial contract in which one party (the protection buyer) pays a premium to another party (the protection seller) in exchange for protection against the risk of default on the underlying assets.

How Credit Enhancements Work in Securitisation Structures

In a securitisation transaction, credit enhancements serve to mitigate the risks associated with the underlying assets, making the resulting securities more attractive to investors. By utilizing internal or external credit enhancement mechanisms, the credit rating of the securities can be improved, leading to lower borrowing costs for the issuer and increased demand from investors.

For example, consider a mortgage-backed security (MBS) backed by a pool of residential mortgages. By incorporating credit enhancements, such as overcollateralisation, subordination, and excess spread, the MBS can achieve a higher credit rating, making it more appealing to institutional investors.