Outline the different kinds of credit enhancement and weigh them up.
The idea
Credit enhancement is any feature that raises the credit quality of a tranche above that of the pool. Internal enhancement comes from within the structure. It includes subordination, where junior tranches absorb losses first, and over-collateralization, where assets exceed notes. It also includes excess spread, which is the pool's weighted average coupon minus note coupons and fees, and reserve or cash collateral accounts. External enhancement comes from third parties, such as monoline insurance or financial guarantees, letters of credit, and guarantees from the originator or parent. Weigh them by cost and risk. Subordination and over-collateralization are reliable but reduce the proceeds the originator can raise. Excess spread is free at closing but varies with prepayments and defaults. Reserve accounts cost carry. External support adds counterparty risk, because a downgrade of the provider can pull down the tranche. The exam point is the internal versus external split and the counterparty risk of external support.
Formulas
Credit enhancement of the senior notes
senior CE = (subordination + OC) ÷ pool
- subordination
- the balance of all notes junior to the senior
- OC
- collateral minus total notes
- pool
- the collateral balance
Count both cushions and divide by the pool, not by the senior balance.
Annual excess spread in money
excess spread = WAC × pool − Σ note coupon × note balance − fees
- WAC
- the pool's weighted average coupon
- pool
- the collateral balance
- note coupon
- each note's coupon rate
- note balance
- each note's balance
- fees
- servicing and other fees
Varies with prepayments and defaults: losing high-coupon loans lowers WAC while fixed note coupons stay the same.
A practice question
What additional risk does external credit enhancement, such as a guarantee from a monoline insurer, bring to a securitization?
- Lower proceeds for the originator, because junior tranches growWhy not: That is a cost of internal enhancement such as subordination, not of an outside guarantee.
- Prepayment risk, because the guarantor can repay the pool earlyWhy not: A guarantee does not change when borrowers prepay.
- Counterparty risk on the provider, whose downgrade can lower the rating of the tranche - correct
- Variable income, because the guarantee depends on the pool's couponWhy not: That describes excess spread. A guarantee is a promise from a third party.
External support depends on a third party staying creditworthy. If the provider is downgraded, the enhanced tranche can be pulled down with it.
A harder one
A trust holds USD 200 million of loans with a weighted average coupon of 8.2%. It has USD 160 million of senior notes at 4.5% and USD 30 million of mezzanine notes at 6.5%, and the servicing fee is 1.0% of the pool. Annual excess spread is closest to:
- USD 7.25 millionWhy not: Omits the servicing fee of 2.0 million.
- USD 3.25 millionWhy not: Deducts the servicing fee twice.
- USD 14.4 millionWhy not: Deducts only the servicing fee from pool interest and ignores the note interest.
- USD 5.25 million - correct
Pool interest 16.4 less senior 7.2, mezzanine 1.95 and servicing 2.0 gives 5.25 million a year, about 2.6% of the pool.
The hardest tier
A securitization has USD 1,000 million of loans supporting USD 800 million of senior notes, USD 120 million of mezzanine notes and USD 50 million of junior notes. Counting subordination and over-collateralization, the credit enhancement of the senior notes as a percentage of the pool balance is closest to:
- 17.0%Why not: Counts only the subordination of 170 million and omits the 30 million of over-collateralization.
- 20.0% - correct
- 25.0%Why not: Divides the 200 million cushion by the senior balance of 800 rather than by the pool.
- 3.0%Why not: Counts only the 30 million of over-collateralization and ignores the junior tranches.
Notes total 970, so over-collateralization is 30. Subordination is 120 + 50 = 170. Senior enhancement is (170 + 30) / 1,000 = 20.0%.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in An Introduction to Securitisation
- State what securitization is, outline its process and account for what each participant does.
- Explain cash waterfall, equity piece, first-loss piece and over-collateralization as they apply within securitization.
- Analyse how issuing securitized products through a trust works differently from using a special purpose vehicle (SPV), and tell apart the three chief SPV structures: amortizing, revolving and master trust.
- Account for why securitization is undertaken and what it offers.
- Account for the tools used to analyse the performance of securitized structures and name the asset classes each suits best.
- Define and calculate, for relevant securitized structures, the weighted average life (WAL), weighted average maturity (WAM), weighted average coupon (WAC), debt service coverage ratio (DSCR), monthly payment rate (MPR), default ratio and delinquency ratio.
- Cover the techniques for forecasting prepayments, and compute the PSA (Public Securities Association) rate along with the CPR (constant prepayment rate).