A method whereby a company attempts to improve its debt or credit worthiness. Through credit enhancement, the lender is provided with reassurance that the borrower will honor the obligation through additional collateral, insurance, or a third party guarantee. Credit enhancement reduces credit/default risk of a debt, thereby increasing the overall credit rating and lowering interest rates.
Credit enhancement is used to obtain better terms for an outstanding debt. Securitization, posting collateral and obtaining external credit enhancement such as a letter of credit are some basic forms of credit enhancement. Firms may also increase cash reserves or take other internal measures to uphold superior solvency ratios.
There are 5 Types Of Credit Enhancement
Here are a few of the different types of credit enhancement that are available.
1. Excess Spreads
Excess spreads is net interest that is left over after all expenses are covered with an asset backed securities. This type of extra interest can be deposited into a separate account in order to provide extra assurances on an investment. The lender will often collect extra money on the spread so that they can make up for potential missed payments in the future.
2. Surety Bonds
Surety bonds are type of external credit enhancement. This is a type of bond that guarantees to pay if the asset-backed security does not meet its obligations. This is basically like a type of insurance policy that is designed to cover against losses. These surety bonds are generally issued by banks and other financial institutions. These can significantly lower the risk of an asset backed securities and make them more attractive to investors.
3. Wrapped Securities
Wrapped securities are another type of credit enhancement. With this type of situation, the asset backed security is insured against any losses by a third-party insurance company. The guarantee that is provided could come in a few different forms. For example, the insurance company could choose to pay back a certain amount of interest or principal on a loan that is not paying. Another option is for the insurance company to buy back some of the loans in the portfolio of the investor.
4. Cash Collateral Account
A cash collateral account is another type of credit enhancement that can be used. With this type of credit enhancement, when the company borrows a certain amount of money and uses it to purchase commercial paper instruments. This commercial paper is considered to be a very low risk investment and it pays a small rate of return. If there is any problem with the asset backed securities, the company can get the cash out of the commercial paper and use it to repay the defaulted loan.
5. Over collateralization
Over collateralization is a form of internal credit enhancement. With this type of credit enhancement, the lender sets up the loan to be worth less than the actual value of the property that is acting as collateral. This is done by using a loan to value ratio. For example, most lenders will only take on a mortgage with an 80 percent loan to value ratio. This means that the value of the mortgage is only worth 80 percent of the value of the property that is acting as collateral. If the loan goes into default, the value of the property will be worth more than the amount that is in default. The bank can then sell the collateral and make a profit.