Credit Enhancement

Credit enhancement is a way of improving the credit quality of a debt obligation by adding protection against losses. The protection may be built into the structure of the transaction or supplied by an outside party, and its purpose is to make the debt safer than the borrower or the underlying assets would be on their own. Issuers use it to reach a target credit rating, lower their borrowing cost and attract investors who can hold only highly rated paper.

The term is most closely associated with securitisation, where pools of loans are funded by notes whose ratings depend on how much loss the structure can absorb before each class of investor is affected. It is also used for municipal and corporate bonds, project finance and trade transactions supported by guarantees or insurance.

Internal enhancement comes from the transaction's own assets and cash flows.

• Subordination. The notes are divided into classes through tranching. Losses are allocated first to the equity tranche, then to the mezzanine tranche, so that the senior tranche is protected by everything beneath it.
• Overcollateralisation. The face value of the assets exceeds the face value of the notes issued, leaving a cushion; see overcollateralisation.
• Excess spread. The interest earned on the assets is higher than the interest and fees paid out, and the difference, the excess spread, absorbs losses first.
• Reserve accounts. A cash reserve is funded at closing or built up from excess spread, and can be drawn to cover shortfalls in interest or principal.
• Performance triggers. If arrears or losses pass set levels, the securitisation waterfall redirects cash from junior to senior investors or begins early amortisation.

External enhancement relies on the credit strength of a third party. Common forms are a guarantee from a parent company, bank or government agency; a standby letter of credit from a bank; a surety bond; and a financial guarantee insurance policy from a specialist bond insurer, often called a monoline. Pool-level mortgage insurance and guarantees from public bodies play a similar role in housing finance. In the United States, the government-sponsored mortgage agencies guarantee timely payment on the mortgage-backed securities they issue.

The weakness of external support is that the enhanced debt becomes exposed to the provider. If the guarantor is downgraded, the supported bonds are usually downgraded with it. This happened on a large scale in 2007 and 2008, when several bond insurers that had guaranteed structured products lost their top ratings during the 2008 financial crisis, and the bonds they had wrapped fell in value.

The level of protection is sized against the losses the asset pool might suffer under stress. Rating agencies model defaults, recoveries and timing for the pool and apply harsher scenarios for higher ratings; a top-rated class must survive a far more severe scenario than a lower-rated one. The result is expressed as a percentage of the pool. If a senior class has 12% enhancement, the pool can lose 12% of its principal before that class suffers any loss.

Enhancement is not fixed for the life of a deal. As senior notes are repaid, subordination grows as a share of what remains, while losses reduce it. Investors therefore follow monthly or quarterly reports that show current enhancement, arrears and the status of triggers.

Credit enhancement has consequences for bank capital. A bank that provides it, for example by keeping the first-loss piece of its own securitisation, holds a concentrated risk position that attracts a high capital charge under the Basel III securitisation framework. Rules in the European Union and the United States also require originators or sponsors to retain a material net economic interest, commonly 5%, so that they keep a stake in the performance of the assets they sell.

For a bank on the receiving side, guarantees and collateral that meet legal and operational conditions can reduce capital requirements as recognised credit risk mitigation. Accounting standards also examine credit enhancement when deciding whether the originator has really transferred the assets or must keep them on its balance sheet.

Enhancement redistributes risk; it does not remove it. Subordination protects senior investors only by concentrating losses on junior ones, and it depends on models of how the assets will behave. Before 2008, many structures backed by subprime mortgages carried enhancement sized on optimistic assumptions about house prices and the correlation of defaults, and senior classes suffered losses that their ratings had implied were remote. Since then, rating methods, disclosure rules and due diligence requirements for investors have been tightened in most major markets.