Senior/Subordinated structures are the most popular technique to create internal credit enhancement. The cash flows generated by the assets are allocated with different priority to classes of different seniority. The senior/subordinated structure thus consists of several tranches, from the most senior to the most subordinated (or junior). The subordinated tranches function as protective layers of the more senior tranches. The class of highest seniority has first right on the available principal cash flows. This structural protection is called the waterfall structure. The priority for the cash flows comes from the top, while the distribution of the losses rises from the bottom. If an asset in the pool defaults, losses thus incurred are allocated bottom up (from the most junior to the most senior tranche). The senior tranche is unaffected unless losses exceed the amount of the subordinated tranches, and is usually rated AAA.
The excess spread is the difference between the interest rate received on the underlying collateral and the coupon on the issued security. It is typically one of the first defenses against loss. Even if some of the underlying loan payments are late or default, the coupon payment can still be made. In the process of "turboing", excess spread is applied to outstanding classes as principal.
Overcollateralization (OC) is a commonly used form of credit enhancement. With this support structure, the face value of the underlying loan portfolio is larger than the security it backs, thus the issued security is overcollateralized. In this manner, even if some of the payments from the underlying loans are late or default, principal and interest payments on the Asset-Backed Security (ABS) can still be made.
A reserve account is created to reimburse the issuing trust for losses up to the amount allocated for the reserve. To increase credit support, the reserve account will often be non-declining throughout the life of the security, meaning that the account will increase proportionally up to some specified level as the outstanding debt is paid off.
External Credit Enhancements:
A wrapped security is insured or guaranteed by a third party. A third party or, in some cases, our parent company since its the ABS issuer will provide a promise to reimburse the trust for losses up to a specified amount. Deals can also include agreements to advance principal and interest or to buy back any defaulted loans. The third-party guarantees are typically provided by AAA-rated financial guarantors or mono line insurance companies such as Prudential.
With a Letter of Credit (LOC), a our financial institutions can provide a specified cash amount to reimburse the ABS-issuing trust for any cash shortfalls from the collateral, up to the required credit support amount.
Stand-By Letter of Credit
With an Stand-By Letter of Credit a financial institution has the surety that a cashed back financial instrument stands in-between the credit grade of their borrower and the underlying asset incase of default. (A Bank Guarantee works in the same manner)
With a cash collateral account (CCA), we can deposit the cash from the proceeds of a trade into a short-term commercial paper that has the highest available credit quality.