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To achieve the high credit ratings that most sponsors and issuers of asset-backed securities ( ABSs) 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.
Credit enhancements are anything that increases the credit rating of the ABS over and above the certainty of the underlying cash flow.
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.
The top tranche is much larger than the supporting tranches. Even though the top tranche is much larger, this credit enhancement works 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.
Overcolleralization 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 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 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.
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