What is Credit Enhancement?
Credit Enhancement is a strategy for improving the credit risk profile of a business or structured financial transaction usually to obtain better terms for repaying debt. Within the financial sector Credit Enhancement may be used to reduce the risks to investors of certain structured financial products or transactions. And/or also to improve the credit profile of borrowers.
The main function is to create more confidence among investors. This is achieved by decreasing the perceived and actual risks of investment losses. And by doing so, expanding the financing resources for the beneficiary borrowers.
In most instances Credit Enhancement is a complex structured financial transaction. It requires strong knowledge and financial capacity of the guaranteeing institution.
Credit Enhancements are useful because they:
- encourage lenders and investors to put money into unfamiliar markets or products (such as renewable energy lending).
- can absorb risk of loss and, as a result, be used as a negotiating tool to convince lenders to reduce interest rates or provide longer loan terms.
- can be used as negotiating leverage to convince lenders to relax their underwriting criteria in order to lend to individuals or businesses with lower than typical credit profiles.
Credit Enhancement occurs when a security’s credit quality is raised above that of the sponsor’s unsecured debt or that of the underlying asset pool. A variety of internal and/or external credit supports are employed to increase the likelihood that investors will receive the cash flows to which they are entitled.
Internal Credit Enhancement
Subordination: A class of securities that function as the protective layer for the secured lenders. If a loan in the pool defaults, any loss thus incurred is absorbed by the subordinated securities
Overcollateralisation: Amount of loan portfolio is larger than the security it backs :
External Credit Enhancement
Surety Bond: A surety bond is an insurance policy provided by a rated and regulated insurance company to reimburse the ABS (Asset Backed Security) for any losses incurred. One major form of credit enhancement is surety bonds. This is a surety instrument utilised ex ante to backstop the main debt. In this instance the Surety bonds are insurance policies stipulating that the insurer guarantees payments of interest and principal to the ABS investors up to a specified amount. An insured ABS is rated equal to the claims-paying rating of the insurance company, typically A rated, because the insurance company guarantees the timely payment of principal and interest on the security.
Parental Guarantee: Another form of third-party guarantee is when the parent company of the issuer guarantees payment. Sometimes, the ABS issuer is supported by a letter of credit (LOC), where a bank/insurance company promises, for a fee, to pay the issuer when the issuer does not have enough to make the current payment
Cash Collateral Account: In this case, the issuer borrows the required credit-enhancement amount, usually from a commercial bank, and then invests that amount in the highest-rated short-term (one-month) commercial paper. Since this is an actual deposit of cash—unlike an LOC, which represents a pledge of cash—a downgrade of the CCA (Cash Collateral Account) provider would not result in a downgrade of the transaction.
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