Investors in asset-backed securities carry all the risks associated with that asset backed security. Hence, the need for credit rating for every such portfolio. Based on the credit ratings, investors in securitization portfolios demand a ‘protection’ against potential default by the borrowers whose loans make up that securitization portfolio. This is referred to as Credit Enhancement.
In this article, we will look at credit rating and credit enhancements: two very important aspects of any securitization portfolio. You will learn:
- Need for Credit Rating of Asset Securitization portfolios
- Aspects involved in Credit Rating a securitization portfolio
- Importance of Credit Enhancement
- Different types of Credit Enhancement
First, credit rating. Securitization portfolios are almost always subject to credit rating by accredited credit rating agencies. Recall that as part of the securitization process, the portfolio of loans to be securitized would have been packaged by the originators, that is, the issuers of the securitization, from out of the loans they would have disbursed earlier.
The originators or the issuers would, therefore, be more aware of the underlying risks in that portfolio than the prospective investors. However, investors carry all the risks in a securitization portfolio and would, therefore, want an independent assessment of the portfolio quality to eliminate potential information asymmetry and consequent adverse selection problems. Hence, the imperative need for credit rating by accredited credit rating agencies of every securitization portfolio.
Credit rating involves a detailed assessment of the following aspects of the securitization portfolio:
- The quality of the loans that make up the securitization portfolio;
- The solvency, that is, the financial stability of the issuer;
- The solidity of the legal structure of the portfolio to ensure adequate protection to the investors;
- Sovereign risk, that is, the perceived risk of the country where the issuer is domiciled. This becomes particularly important if the investors in the securitization portfolio are based in countries other than where the issuer, and, therefore, the securitization portfolio itself is domiciled. For example, a securitization portfolio originated by a mortgage bank in the United States could be bought and subsequently traded by entities domicile outside the United States.
- Next, the extent of prepayment risk, that is, the likely impact on future cash flows to the investors should the underlying loans be prematurely closed. We will discuss the causes and consequences of prepayment risk in another article.
Now, let’s look at credit enhancements. As already discussed, investors in a securitization portfolio carry all the risks associated with that portfolio, although they would neither be aware of who the borrowers are nor would they have a role in the credit appraisal process prior to the disbursement of the loans that make up the securitization portfolio.
Therefore, investors in securitization portfolios normally structure a protection against potential default by the borrowers whose loans make up that securitization portfolio. This protection is referred to as credit enhancement and is structured in several ways, some of which we will discuss here.
First of all, cash collateral. Based on an assessment of the probability of default in that securitization portfolio and the expected losses given default, the originator will be called upon if the terms of securitization so mandates to provide or set aside cash as a collateral that will be used to repay the investors in the event of default by the borrowers.
The second type of credit enhancement is the more traditional insurance or guarantee. In this method of credit enhancement, the originator seeks a third party, such as an insurance company, to provide a credit insurance or a bank to provide a bank guarantee, which will be invoked in the event of defaults in the repayment in that securitization portfolio.
The third type, which has gained in popularity in the last decade or so, is called structural credit enhancement. This form of credit enhancement involves splitting the securitization portfolio into three or more classes with varying levels of guaranteed return on the portfolio. In securitization markets, this is referred to as a subordinated structure and requires each lower class investor to provide protection to the next senior class.
Structural credit enhancement
Hence, the junior-most class absorbs the first risk of default. Returns are, therefore, top down, that means, the senior-most class gets the lowest return because they take the least amount of risk on that portfolio.
They take the least amount of risk on that portfolio 500 million CCU. The highest class, class A investors, let us say, subscribe to 350 out of that 500 million with a guaranteed return of 3%. The next class, class B, would subscribe to 100 million CCU with a guaranteed return of 5%, and the last, class C, will subscribe to 50 million CCU with a guaranteed return of 8%. Let us say, CCU 10 million worth of loans defaults in the securitization portfolio, in other words, repayment not received well after the due dates.
Then, the junior-most tranche, class C, would be called upon to make good the default of 10 million CCU. As a result, investors in that tranche will find their invested capital erode by 20% from CCU 50 million to CCU 40 million.
In effect, up to 10% of default in this portfolio, 50 million CCU out of 500 million CCU, will be borne by investors in the junior-most tranche, that is, class C. If the quantum of default in that portfolio exceeds 50 million currency units it would devolve on the next tranche, which is class B.
That’s a brief exposition of how structured credit enhancements work, and as I said before, this is a very popular form of credit enhancement, particularly in the securitization market in the United States.