Credit enhancement and credit tranching

What is credit enhancement?

Credit enhancement is any feature that absorbs losses before they reach the investors. It is what lets bonds backed by risky loans earn high ratings. There are two families.

Credit enhancementabsorbs losses before they reach investors

• Internal Memorize built into the deal itself
  • Overcollateralization Memorize pool worth more than the notes
  • Excess spread Memorize pool interest above note interest and fees
  • Subordination (credit tranching) Memorize junior classes take losses first
• External Memorize a third party stands behind the deal
  • Financial guarantee Memorize from a bank or insurer
  • Letter of credit Memorize a bank promises to pay up to a limit
  • Cash collateral account Memorize cash funded by a third party and held as a reserve

An internal credit enhancement is built into the structure of the deal. An external credit enhancement comes from a third party, so the deal also depends on that party’s own credit.

How do the three internal enhancements work?

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Overcollateralization . The pool is worth more than the notes issued. The extra assets take losses before any noteholder does.

$$OC = \text{Pool} - \text{Notes}$$

$$\frac{OC}{\text{Notes}} = \frac{\text{Pool} - \text{Notes}}{\text{Notes}}$$

Excess spread . The pool earns interest, and the notes and fees take only part of it. What is left is available to absorb losses or to build a reserve. In its simplest form it is the pool’s coupon minus the notes’ coupon. When servicing or other fees are given, take them off too: only what is left after them can absorb losses.

$$ES = y - c - f$$

Subordination (credit tranching ). The notes are cut into classes that share losses in reverse order of seniority. This is a senior/subordinated structure . Cash flows through a waterfall : payments go down from the senior class, and losses go up from the most junior class. The bottom class, often unrated, is the equity tranche because it holds the residual claim.

How are losses allocated across tranches?

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Fill the classes from the bottom. A tranche loses nothing until every tranche below it is gone.

$$\text{Loss} = \min\bigl(\text{Size},\ \max(0,\ L - \text{tranches below})\bigr)$$

Class A is protected until losses exceed the classes beneath it.

$$K = \text{Mezzanine} + \text{Junior}$$

Here K = 72 + 48 = EUR 120 million, which is 20% of the EUR 600 million deal.

Each class gets its own rating, based on the quality of the pool and its position in the waterfall. The senior class can be rated above the company that originated the loans.

What are the external enhancements?

An external enhancement is a commitment from a third party. A financial guarantee from a bank or insurer pays if the pool falls short. A letter of credit is a bank’s promise to provide funds up to a limit. A cash collateral account is cash funded by a third party and held as a reserve. All three add credit risk: if the provider is downgraded, the protection is worth less.

Exam tip Ask where the protection comes from. Inside the deal’s own assets, income or structure: internal. A bank or insurer outside the deal: external.

Go deeper Why the junior tranche is called equity

The most junior class has no promised coupon in many deals. It claims whatever is left after the senior classes are paid, much as shareholders claim what is left after creditors. It also absorbs the first losses. That is why it is called the equity tranche, and why it is the riskiest and highest-yielding slice.

Go deeper Tranche ratings and the issuer's rating

A tranche is rated on the pool and its place in the waterfall, not on the company that sold the loans. A new kind of deal may need a large cushion, with heavy overcollateralization, before rating agencies grant an investment-grade rating. The same pool can therefore produce a AAA senior class and an unrated junior class.

Go deeper Combining the three

Most deals layer them. Excess spread covers the first, small losses each period. Overcollateralization is the next cushion. Subordination protects the senior class from the larger losses. An external guarantee, if any, sits on top. The more layers below you, the safer your tranche.