Understanding How Credit Enhancement Works

May 29, 2010 - PRLog -- When it comes to structured finance credit enhancement is the use of a technique of risk reduction that protects an investor against any losses in terms of a debt instrument or an underlying security. It is an important tool for credit rating agencies to use when they are rating a securitization. According to InvestorWords.com the definition of such is “The process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted.”

To look at it from a banking point of view, credit enhancement is a technique that can help to improve the credit rating of a security or bond that is asset backed. It improves the marketability of an asset. The strategies for enhancement are often used in public financing as well as private project financing. It is also an integral aspect of structured finance.  http://www.economywatch.com/finance/high-finance/credit-enhancement.html


There are two primary kinds of credit enhancement. There is internal and external. Some examples of internal enhancement include excess spread, overcollateralization and reserve account. Examples of external enhancement include surety bonds, wrapped securities, letter of credit and cash collateral account.  These are all legitimate means of enhancing the financial stability of a debt tool.

One very popular method is overcollateralization (an internal enhancement method). For those unsure as to what collateral is, it is property which is pledged as a form of security when an individual has a debt to repay. A mortgage is an example of such a debt. If the individual in question defaults on the mortgage then the bank has the right to seize the property that was held as collateral as repayment for the loan.

If a company wants to issue bonds or some other kind of debt instrument it can pledge assets as collateral for the debt in question. In most cases the assets pledged would be equal to (or almost equal to) the amount of money that is to be borrowed. If the company wants to improve the credit rating of its notes or bonds then it would be smart to pledge assets that have a higher value than the amount of the debt.

Credit enhancement is an extremely important element of securitization which is a type of structured finance. What this means is that a non-liquid asset is able to be turned into a security that is more liquid in nature. The most common of these include mortgage-backed securities (MBS) and asset-based securities (ABS).

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