Credit enhancement
By using additional security instruments (credit enhancement) it is possible to transfer a loan portfolio which contains individual assets with an average rating of BBB or even lower into securities which are mostly AAA-rated.
The most important credit enhancement instruments are:
- Dividing the portfolio into first-ranking and subordinated structures, i.e. senior and junior tranches. The subordinated security tranches serve (in the order of their subordination) as a risk buffer and interest and redemption payments are made on these tranches only when the claims of the AAA-rated first-ranking senior tranche have been satisfied (basic principle of ABS).
- A positive interest spread between the interest received from the portfolio and the interest paid to the investors (excess spread) also serves, in part or in full, as security for the investors.
- Overcollateralisation, in which the underlying loan portfolio is larger than the volume of notes issued for which it serves as collateral.
- External enhancements such as the purchase of an external insurance policy to cover loan losses or a guarantee.
A combination of different credit enhancement instruments is typically used.