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. Credit enhancement levels are determined relative to a specific rating desired by the issuer for a security by each rating agency. There are two general types of credit enhancement
1. External Credit Enhancements:
a) Third-Party or Parental Guarantees (Bond issuance): A third party e.g. an insurer, or the parent company
of the seller/servicer promises to cover losses that may arise on non-performance of the collateral up to a stated maximum dollar amount. Unlike municipal bond insurance which guarantees the entire principal amount, the guarantee in a securitization is only for a percentage of the par value at origination. For example, a $100 million securitization may have only $5 million guaranteed by the monoline insurer.
b) Letter of Credit (LOC): In this case a financial institution, typically a bank, is paid a fee to reimburse the trust for any losses actually incurred, up to the required credit-enhancement amount.
c) Corporate guarantees: Usually provided by the issuer of the ABS or its parent company.
Letter of credit from a bank and a guarantee by the seller of the assets are two less common forms of credit
enhancement because of the “weak link approach” employed by rating agencies. According to this approach, if an issuer seeks a triple A rating for one of the bond classes in the structure, it would be unlikely to be awarded such a rating if the external credit enhancer has a rating that is less than triple A. External credit enhancement exposes the investor to “third-party risk,” where the ABS rating will be dependent on the creditworthiness of the institution.