Introduction to Securitization

CHAPTER 5

Credit Enhancements

While there are various types of credit enhancement, the nature and extent of credit enhancement required in a transaction is specific to the type of asset securitized and the type of investor targeted. There are some forms of credit enhancement that are more suitable for certain types of assets but would be totally inappropriate for other types. All credit enhancement has a cost associated with it. An economic analysis of the cost of further enhancement of a structure versus the improved execution of the transaction will be performed by the structurer.

The amount or size of credit enhancement needed to obtain a specific credit rating is specified by the rating agencies from which a rating is sought. A rating agency does the sizing of the credit enhancement and the structurer determines the best mix of credit enhancements to achieve the amount specified by the rating agency. The factors considered by rating agencies in sizing a transaction are (1) the obligor’s incentives to default; (2) the credit quality of the obligors; (3) the likely loss scenario and the potential variability of loss; and (4) the diversification of the asset pool.²⁹

The credit enhancement level for every bond class in a structure to be rated is based on the target rating sought for that bond class. For instance, for a rating agency to award a triple-B rating to a bond class, the probability of any losses in the portfolio impacting the triple-B bond class must not be more ...