Lesson 2 of 7 · All lessons in this module
- Covered bonds: dual recourse and a dynamic pool
- Credit enhancement: OC, excess spread and tranchingVideo lesson
- Integrated cases: who is paid, and when, in a tranched ABS
- Amortizing vs non-amortizing collateral: credit card ABS
- Solar ABS
- CDOs: managed pools and leveraged equity
- CLOs: capital structure, tests and the manager
Lesson 2 of 7 · 15 min
Credit enhancement: OC, excess spread and tranching
Securitizations protect bondholders from defaults in the pool with extra collateral, extra interest and a loss waterfall in which junior tranches are wiped out before senior ones lose anything.
In short
- Credit enhancement: financial support that absorbs losses from defaults on the underlying loans.
- Three main internal enhancements: overcollateralization (pool value > bonds' face value), excess spread (collateral coupon − coupon paid on the securities) and subordination (credit tranching).
- External enhancements come from third parties: bank or insurer financial guarantees, letters of credit and cash collateral accounts.
- In a senior/subordinated (waterfall) structure, the most junior tranche absorbs losses first; the senior tranche loses only once every class below it is wiped out.
- Each tranche is rated on the quality of the collateral and its own seniority, so a senior tranche can be rated above the company that originated the loans.
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