5 Types of Credit Enhancement

Credit enhancement is a term used to describe a financial process designed to lower the risk of securities for investors. This process is critical to credit rating agencies when they are coming up with ratings for investments. Here are a few of the diverse types of credit enhancement that are available.

1. Excess Spreads

Excess spreads are net interest that is left over after all expenses are covered with asset-backed securities. This type of extra interest can be deposited into a separate account to provide extra assurance 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 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 like a type of insurance policy that is designed to cover losses. These surety bonds are issued by banks and other financial institutions. These can significantly lower the risk of asset-backed securities and make them more attractive to investors.

3. Wrapped Securities

Wrapped securities are another type of credit enhancement. In 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 paid. 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. This type of credit enhancement is when the company borrows a certain amount of money and uses it to purchase commercial paper instruments. This commercial paper is 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. Overcollateralization

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. 

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