Credit Enhancements

Asset-backed securities (ABSs) derive their value from the underlying assets, but the securities themselves can have different credit ratings to appeal to different market segments. Pension funds, for instance, only want to buy securities with the highest credit ratings, while hedge funds generally want to buy lower rated securities with higher yields. An issuer of asset-backed securities can achieve these goals by issuing securities with a divided interest in the underlying assets, each interest with different credit ratings. Credit enhancements achieve these different credit ratings by providing different levels of support and different levels of claims against the cash flow and the principal of the underlying assets. So some securities from an underlying pool of assets can be issued with higher credit ratings than the underlying assets would justify, but, perforce, the remaining securities issued from the same pool must have a lower credit rating.

To achieve the high credit ratings that most sponsors and issuers of asset-backed securities desire, a credit rating agency, such as Standard & Poor's Rating Service, Moody's Investors Service, or Fitch Ratings, is consulted to determine what the rating agency requires of the ABS to receive its highest credit rating. The credit rating agency judges the credit quality of an ABS by considering its structural characteristics, its cash flow, and its ability to withstand financial stress through the use of stress testing, which is a financial model that calculates the outcomes of specific, possible scenarios in which the cash flow is altered, such as assuming different default rates or prepayment characteristics. Hence, it is the rating agencies that decide what credit enhancements an ABS needs to achieve its highest credit rating.

Internal Credit Enhancements

Internal credit enhancements are structural details of the ABS that increases its credit quality, which includes the use of supporting tranches, overcollateralization, and yield spreads.

Almost all ABSs have different classes, or tranches, of securities with different ratings. This type of structure is often termed a senior/subordinated, or A/B, structure, with the subordinated structures receiving most or all of the losses. Because of the greater risk, ABSs based on supporting tranches pay a higher yield. Usually, the issuing trust retains the bottom, unrated tranche, which is often referred to as the equity tranche and can provide the highest yield if losses are minimal. The equity tranche is the equity provided by the sponsors of the ABS and is the 1st to absorb losses, in much the same way that the owners of a bank are the 1st to absorb losses, since losses are 1st subtracted from the bank's equity, before any creditors have to suffer losses.

The top tranche is much larger than the supporting tranches. Even though the top tranche is much larger, this credit enhancement will usually work because the number of defaults will be low relative to the number of accounts that the security is based on. However, if the default rate is high enough it may affect the top tranche as well, as has happened with many asset-backed securities based on subprime mortgages and other subprime loans.

Overcollateralization helps to absorb losses, because the value of the loan portfolio is greater than the value of the ABSs based on the portfolio. The greater the difference, the greater the protection that overcollateralization offers.

The yield spread is the difference between the yield of the ABS and the yield being paid on the underlying portfolio. In some cases, such as with ABSs based on credit card receivables, the yield spread can be very large.

The yield spread can also generate an excess spread, which is the amount left over after all expenses and ABS holders have been paid. The excess spread is paid into a reserve fund, which will help cover any future shortfalls. However, the sponsor of the ABS may retain the excess spread for its own profits or to cover losses by retaining the bottom tranche.

External Credit Enhancements

External credit enhancements increase the credit rating of the ABS by external support, either by 3rd parties or external funding. When support is provided by 3rd parties, there is a third-party risk to the security. If the credit rating of the 3rd party is downgraded, the price of the ABS in the secondary market will decrease.

One major form of credit enhancement is surety bonds, which are insurance policies stipulating that the insurer guarantees payments of interest and principal to the ABS investors, up to a specified amount. Another form of 3rd party guarantee is when the parent company of the issuer guarantees payment. Sometimes, the ABS issuer is supported by a letter of credit (LOC), where a bank promises, for a fee, to pay the issuer when the issuer does not have enough to make the current payments.

There are 2 other forms of external credit enhancements that are not subject to 3rd party risk, since the issuer already possesses the cash collateral: cash collateral accounts and collateral invested amounts.

A cash collateral account (CCA) is an account of the issuer that is used to support any shortfalls in income. The money is borrowed from a bank and invested in 1-month commercial paper, so if the issuer doesn't have enough money to make the monthly payments, it will use the money from the maturing commercial paper to pay the coupon payments of ABS investors. The account is reimbursed from future excess spreads.

A collateral invested amount (CIA) is a fund whose source was either an investment by a 3rd party credit enhancer or by the sale of a subordinated tranche to a few wealthy investors as a 144A private placement. The tranche is often customized specifically for the investors. Like the cash collateral account, the CIA fund is reimbursed from future excess spreads.

Limitations of the Credit Rating Agencies and their Role in the Credit Crisis

The major flaw in relying on credit rating agencies to assess securitized debt is that they can only assess the systemic risk of the securities, which is the risk that a decline in value of the underlying securities results from a general cause, such as a decline in the overall economy. Credit rating agencies can also examine the overall organization of the security, such as its credit enhancements, but they lack the means of assessing the creditworthiness of the borrowers in the securitization pool. For asset-backed securities based on loans, only the loan originators can accurately assess the creditworthiness of borrowers. Since loan originators earned fees from originating and servicing the loans and could pass the credit default risk to the buyers of the asset-backed securities, they had a greater incentive to originate more loans, even if the borrowers were not creditworthy. This flaw in the structure of asset-backed securities seems to have escaped the notice of the credit rating agencies.

Furthermore, because the credit rating agencies earned hefty fees for their consulting services in structuring asset-backed securities and because they competed with the other agencies for business, they had a strong incentive to give the highest credit rating to these securities.

To increase their profits, loan originators started, in 2003, granting loans to subprime borrowers, many of whom were unable to pay back the loans. Hence, the credit enhancements could not compensate for the large number of subprime borrowers in the securitization pool, so many of the asset-backed securities, particularly mortgage-backed securities, suffered large losses — even buyers of the most senior tranches suffered losses. Because of the increased risk of these securities, which were often used as collateral for repos, the lenders started requiring a larger haircut, which is the spread between the loan amount and the amount of the collateral that had to be posted. In many cases, lenders would not accept debt securities as collateral. Both results caused a decrease in the money supply, which contributed to the 2007-2009 credit crisis.