One of the major risks in securitization relates to the variability of cash flows from the underlying assets. If mortgage borrowers default or prepay their loans faster than expected, there may not be enough cash flow for the SPE to fully pay investors.
Credit enhancement refers to a method of protecting investors from potential losses or shortfalls in cash flows. Enhancements improve the credit rating and reduce the credit risk associated with securitized assets. With credit enhancement, the securities can achieve higher ratings than the underlying assets could obtain on a stand-alone basis.
Types of Credit Enhancement
There are several ways to provide credit enhancement:
Overcollateralization
Overcollateralization means the value of the assets in the pool is higher than the face value of the securities issued. For example, a pool with $100 million of mortgages might back $80 million of securities. The extra collateral provides additional loss protection for investors. Cash from excess collateral is used to make up shortfalls if expected payments are not made.
Excess Spread
Excess spread is the difference between the interest rate collected on the pooled assets and the rate paid out on the securities. If the mortgages have a collective interest rate of 6% and the securities have a 4% coupon, then there is 2% excess spread. This 2% provides a cushion against losses. Any excess spread leftover after covering losses goes to the residual holder as profit.
Reserve Funds
Sometimes the SPE will have a segregated reserve fund from proceeds of the offering. This reserve fund can be used to cover shortfalls or smooth timing differences in cash flows from the underlying assets. It provides an initial level of overcollateralization to absorb losses.
Subordination
Subordination divides securities into tranches based on seniority. Junior tranches suffer losses before more senior tranches. Cash flows are directed sequentially, starting with the senior securities. Losses hit the bottom tranches first while the senior tranches are protected from losses up to specified levels.
For example, securities might be split into a senior AAA piece, a mezzanine BBB piece, and a junior residual piece (unrated equity). The AAA class gets first claim on cash flows so it has less default risk compared to the underlying assets. If there are losses, the residual piece takes the first hit. The subordination provides credit enhancement to more senior tranches.
Calculating Required Credit Enhancement by Tranche
The level of credit enhancement needed varies based on the desired rating for each tranche. More junior tranches that absorb initial losses require a higher level of protection. Enhancement level is measured by looking at three key ratios:
Subordination Ratio
Measures credit support from classes junior to that tranche:
Subordination Ratio = Size of Classes Junior to Tranche / Size of All Tranches
For example, if total issuance is $100mm and the junior tranche is $20mm. Then the subordination ratio for the senior tranche would be 20% = ($20mm / $100mm).
Overcollateralization Ratio
Measures level of overcollateralization based on excess collateral:
OC Ratio = (Principal Balance of Collateral Pool) / (Principal Balance of All Tranches)
For example, if $100mm of assets backs $80mm of all tranches, then OC Ratio is 125% = ($100mm / $80mm).
Total Enhancement
Sum of credit support from subordination and overcollateralization:
Total Enhancement = Subordination Ratio + (OC Ratio – 100%)
In our example with 20% subordination and 125% OC ratio, Total Enhancement for senior tranche is 45% = (20% + (125% – 100%)).
To set enhancement levels, rating agencies estimate cumulative losses under stress scenarios based on historical data. Then they solve for the overcollateralization and subordination needed to cover those losses at each rating level.
Tranches with higher ratings require lower total enhancement. More junior mezzanine and equity tranches require progressively higher enhancement to achieve desired ratings.
Benefits of Credit Enhancement
In securitization, credit enhancement increases ratings, reduces credit risk for senior tranches, and lowers funding costs. Enhancement makes the securities viable for more investors by transforming higher risk assets into conservative investment grade tranches. For example, a pool of junk bonds might be turned into AAA, BBB, and residual equity tranches using overcollateralization and subordination. Without enhancement, the junk bond pool could not directly receive an investment grade rating.
Enhancement also boosts deal profitability because excess spread not needed for losses flows to equity holders. In some deals, enhancing senior tranches allows issuance of larger senior and junior tranches compared to issuing just a single tranche security. By enhancing senior notes with overcollateralization, subordination, and excess spread, there are also more residual cash flows shielding junior tranches.
Conclusion
Credit enhancement is an integral tool in securitization to raise ratings, lower credit risk, and attract investors. Enhancement comes from overcollateralization, excess spread, reserve funds, and tranche subordination. The level of enhancement needed varies based on desired ratings and cumulative loss estimates under stress scenarios.