5.6.1 Definition and sizing
Any structural feature or counterparty that is used as part of a structured finance transaction to enhance the pure credit quality of the underlying assets to the level of the desired ratings can be described as ‘‘credit enhancement’’ or ‘‘credit enhancers’’ (in the case of a counterparty).
The purpose of credit enhancement is twofold: absorbing losses on the assets that are financed via the transaction and enabling the originator/issuer to structure the transaction so that, as a result of these activities, the resulting different bond tranches carry different risk, which is expressed by different pricing, different ratings, and different investor types for the resulting tranches. This activity is also known as ‘‘tranching’’ or ‘‘sizing the credit enhancement and capital structure’’.
The size of the credit enhancement is determined to absorb expected losses that assets could experience during the transaction’s lifecycle and therefore serves as a cushion put in place to protect investors against such losses. The rating agencies’ rating criteria play a key role in determining the size of the required credit enhancement and the higher the quality of the required rating for a particular tranche, the greater the protection required.
Credit enhancement is sized to protect investors from expected losses, which in turn can arise from a variety of risks, such as commingling risk, setoff risk, servicer and other counterparty risk, risk of cash transfer delays, etc.—to name a few.
In practice, a particular deal’s credit enhancement is usually a combination of several forms of different credit enhancement mechanisms. Given that this is something the originator needs to provide for as part of structuring the transaction, credit enhancement is also a reflection of the specific
Table 5.2. The three funding alternatives from the originator’s point of view
Multi-seller conduit Public ABS Private ABS
Pros m Can handle smaller size m Large size (up to ẳc2–3bn) m Can handle smaller size transactions (ẳc250m) m ‘‘Halo effect’’ of AAA transactions (ẳc250mỵ)
m Proven track record: price, issuer in the market; public m Lower transaction costs structure, execution perception of the originator (no SEC registration) m Established investor and m Diversification of the investor m Disclosure to a limited
rating agency relationships base; wider distribution than investor group
m Easy and fast to execute; private ABS
no rating required with m Tightest pricing
bank’s conduit programs m Term funding; no price risk m No seller name in the
market, only vehicle name m Black-box AAA/Aaa term funding through the conduit
Cons n Need liquidity (backstop n Minimum size (ẳc250mỵ) n Higher spreads than public purchase commitment) n Requires SEC registration market
n Market practice is 364-day n Disclosure of portfolio n More limited investor base
commitment data to public than public market
n Seller rating downgrade n More detailed reporting n More detailed reporting
trigger requirements requirements
n Banks have a limited n Longer execution time n Longer execution time group capacity n Significant rating agency
n Price risk; weighted average involvement funding cost plus spread
characteristics of the securitized assets, the overarching goals of the securitization sponsor, and last but not least the requirements of the rating agencies.
Although rating agencies are keen to stress that they are not actively consulting and structuring on behalf of the originator, they play a key role in sizing the credit enhancement by means of an iterative process whereby the originator provides the transaction’s details and credit enhancement and the agencies model the transaction and then give their feedback to the originator on whether the enhance
ment provided is sufficient for the relevant rating band. If not, the originator would then have to try and understand what is needed in order to satisfy the agencies’ rating requirements and provide the additional level of credit enhancement in order to address the unfavorable eventualities that could adversely affect the bond over the deal’s life.
Internal and external credit enhancement
Internal credit enhancement means that it is provided within the structure by the originator or through internal mechanisms as part of the actual deal structure. Internal credit enhancement can further be separated into
. Hard credit enhancement. This is usually static (i.e., does not change) and exists from the inception of the transaction. Due to its static nature it is not expected to ‘‘disappear’’ when it’s needed most (i.e., when problems with the underlying assets arise, cash flows from the asset dry up, and the investors then have to rely on protection provided by the structure itself ). Typical examples of such hard credit enhancement are
e Subordination
e Overcollateralization
e Static or fixed reserve funds or cash collateral accounts
e Trigger events
e Maintenance of certain financial ratios
e Insurance cover provision on the underlying assets, such as mortgage payment protection.
. Soft credit enhancement. This is usually of a dynamic nature, it can change frequently, and it may start with a minimum requirement and will be built up over the life of the transaction. Due to its changing nature it can potentially ‘‘disappear’’ when it’s needed most and the availability of it should be monitored carefully. From an analytical perspective, it makes sense to assume this kind of credit enhancement is not available and hence ignore it in the analysis when looking to invest—and by doing so removing any reliance on it. Examples of soft credit enhancements found across a wide range of structures are
e Excess spread
e Dynamically reducing reserve funds or cash collateral accounts.
External credit enhancement, in contrast, is provided outside the transaction’s structure itself and usually by counterparties or guarantors other than the originator. Section 5.6.2 takes a closer look at both types of credit enhancement.
5.6.2 Internal enhancement
Commonly used types of internal credit enhancement for a variety of asset classes are
. Subordination. Subordination assigns a different ranking order to issued note obligations which are all secured by the same pool of underlying assets. This ranking determines how losses experienced in the asset pool are distributed to the various note tranches. This means that junior tranches would usually be hit first by losses (hence they are also commonly referred to as ‘‘first-loss tranches’’) which, after the junior tranches have been eroded, may ‘‘eat’’ further into the capital structure and also incur losses for the mezzanine and, in extreme cases, also for the senior noteholders.
Subordination, expressed by different note tranches as part of the same issuance, usually also impacts the allocation of cash flows (the so-called ‘‘waterfall’’) which are generated by the under
lying assets in order of note seniority. This would, for instance, mean that senior tranches receive the cash flow generated by the underlying assets first and subordinated bond tranches will profit from cash flows last. Equally, loss absorption by the note structure would impact the first-loss tranche initially and then the junior notes next and the senior notes last.
Originators tend to hold the equity or first-loss tranches, which are the most junior tranches in the majority of transactions. These tranches serve as an incentive for the originator to assure that the transaction is performing according to expectations, as losses will impact them (i.e., the originator’s first). This is, however, no guarantee that the transaction will actually perform as expected.
Timely subordination is usually a consequence of the transaction’s legal documentation, whereby some payments are subject to certain conditions being met or otherwise may be delayed until a breach of those conditions has been remedied. From an investor’s point of view it is important to know, for instance, whether the senior tranches you are investing in are subject to timely sub
ordination, which may disadvantage you compared with mezzanine and/or junior noteholders, even if you are structurally a holder of a senior note tranche.
Structural subordination is where the chosen structure determines the actual structural position of noteholders—in other words, are you a senior noteholder (i.e., at the top of the structure, enjoying the highest ratings and the greatest credit protection) or a junior note investor (i.e., sitting
structurally at the bottom with limited credit enhancement and the lowest ratings)? In this context, it is also important to be able to distinguish between both forms of subordination. The following structure serves as an example:
Class A (AAA-rated)
Class B (BBB-rated) (structurally subordinated to Class A)
Class C (B-rated) (structurally subordinated to Class A and Class B)
Class A will receive principal repayments first, then Class B, then Class C. But, Class C will receive interest payments first, then Class B, then Class A, which means that interest payments in this structure would be in ‘‘reverse sequential’’ order; or, in other words, interest payment for Class A notes is timely subordinated to interest payments of Class B and Class C.
The key benefits of subordination are that it is typically available as soon as the deal has been established and the issuance is closed. Furthermore, it is usually static and is not linked to the performance of the underlying assets or the performance of the originator/issuer and as such provides fairly stable protection.
Due to the way this type of credit enhancement is calculated, certain structures have growing subordination levels relatively over time when some of the senior tranches are paying down. Whilst the provided levels of subordination—which are typically expressed as a percentage—do not change, the relationship of the available tranches to each other changes when tranches within such structures are paid down or redeemed and consequently relative subordination or relative credit enhancement in % may change (i.e., increase).
Whereas some forms of credit enhancement (e.g., ‘‘excess spread’’) may be made available on a
‘‘use it or lose it’’ basis at a certain interest payment date (IPD), subordination is constantly available throughout the life of the transaction.
. Reserve accounts. These accounts provide a liquid source of protection within a structure that either already holds at transaction close a predetermined amount of cash (or cash-near liquid instruments) or serves to redirect part of interest and/or principal receipts from the transaction’s waterfall and accumulate them in the relevant ‘‘reserve ledger’’ or reserve account.
The purpose of this account is to park funds until they either need to be used to make up—
depending on the individual structure—interest or principal shortfalls on the notes or, ultimately, if they have not been utilized, they can be returned to a predetermined counterparty other than the noteholders, typically the originator. Such reserve accounts can either be prefunded by utilizing some of the proceeds from the note issuance at outset of the transaction that are put aside as cash.
Alternatively, the structure may have a ramp-up period, typically 6 months to 1 year, during which cash collateral—likely to be funded by all or some excess spread payment—can build up within the dedicated reserve account.
On the occurrence of certain trigger events that are, for instance, linked to the servicer’s credit ratings or the performance of the underlying collateral, the reserve account may be contractually required to increase further to cover the additional risk that may arise from a weaker servicer or decreasing asset performance. Equally, if a transaction amortizes, issuers may be permitted to release some of the cash held in the reserve accounts, which means that this cash is then leaving the structure and will no longer be accessible to noteholders.
. Overcollateralization. This occurs when the value of the underlying assets exceeds the face value of the issued notes. For instance, if the value of the underlying securitized asset pool is £550m, but the notional value of the outstanding notes at issuance is only £500m, this means that the securitized assets of £550m were essentially purchased at a discount of 10% and the transaction is in essence overcollateralized by 10%, meaning 110% assets compared with 100% issuance. The overcollater
alization rate (OC) in this example is 110% or 1.1� (ẳ110/100 and also ẳ 550/500). Such a level of
overcollateralization reflects the level of expected losses for this pool of assets and is also an expression of expected deal expenses.
OC within a structured transaction is meant to absorb losses second in line after excess spread (which is usually the first line of defense) but prior to passing on any losses to the noteholders. The amount of OC provided is usually fairly small (since the provision of it can be quite expensive for originators/issuers who could use the collateral utilized for the resulting overcollateralized part more efficiently in similar transactions). Furthermore, junior noteholders are the ones who benefit most from the availability of overcollateralization (as second line of defense) given that they themselves are the third line of defense—in the form of subordination they are providing to mezzanine as well as senior noteholders.
Overcollateralization can be fully funded at deal inception or can be structured in a way that it builds up (or decreases) over time throughout the life of the transaction. Due to such built-in fluctuations as well as the nature of the underlying collateral (which is usually a dynamic pool of assets) the overcollateralization rate in transactions will usually vary over time.
In order to protect investors from disadvantageous changes, many transactions contain certain OC triggers that ensure that a minimum level of OC is maintained and if the level falls below the trigger level, early amortization of the transaction may be initiated.
. Trigger events. Trigger events are another important structural feature: the occurrence of specified trigger hits such as exceeding pool concentration limits (e.g., TOP 5 borrower or industry con
centration) or deterioration of the underlying pool quality (e.g., for rising delinquencies, losses, and defaults) triggers subsequent events. Such trigger events can be as far reaching as cash flow redirection within a deal structure or even early amortization and wind-down of a transaction.
It is therefore important that such triggers and also the non-occurrence of trigger events are frequently reported as part of the transaction’s regular investor reporting.
Trigger events that are defined by the transaction’s legal documentation and that impact the transaction in case of a trigger hit are sometimes referred to as ‘‘hard triggers’’. In addition to these hard triggers, sophisticated investors may also use ‘‘soft triggers’’ internally, which have no direct impact on the transaction itself but can serve more as an internal early-warning mechanism. These soft triggers can be extremely useful for surveillance and performance analysis undertaken by investors: for instance, if a performance indicator came within, say, 25% (the soft trigger level) from the transaction’s hard-trigger level (e.g., cumulative losses), then the investor may wish to consider some action for this particular bond.
Rating agencies also use soft triggers in their surveillance and performance analysis function to identify potential problems early, before any hard trigger will be hit, and would then place a transaction on rating watch negative while further investigating the reasons for these performance outliers.
. Minimum debt or interest service coverage levels (DSCR or ICR) and other financial ratios. These levels measure, over a specified period of time (3-month DSCR, 1-month DSCR), if the cash flows generated by the underlying assets exceed the interest or debt service requirements of the securitiza
tion transaction. The actual coverage ratio is then compared against the expected ratio for the same period of time, which enables rating agencies as well as investors to monitor the performance of the transaction and, in case of adverse performance, trigger certain events such as early amortization of a transaction.
. Subordinated loan(s) provided by the originator. As part of the actual transaction structure these loans can also serve as internal credit enhancements to a securitization. Such loans could, for instance, serve to provide an initial amount to fund a transaction’s reserve account at the outset of the deal which would usually contribute to the deal’s total credit enhancement. Typically, these funds are either repaid once the transaction has redeemed, or once sufficient funds have been
generated and a portion of the cash flows generated after close of the deal have been accumulated in the reserve account which permit early redemption of the originator’s funds.
. Excess spread. As mentioned in the overview section on credit enhancement, excess spread is a dynamic form of soft credit enhancement that by its nature will likely change from one interest payment date (IPD) to the next. Excess spread is in essence the difference between revenues generated by the securitized assets—usually interest cash flows—and the transaction expenses, such as interest payable to the noteholders, servicing and operating fees, and losses on the underlying assets, etc.
Securitized assets generate revenue streams, normally either in the form of pool interest or rental payments. These revenue streams generated by the underlying assets and prior to any deduction or diversion of this spread can be considered as gross yield. These cash flows are then used to cover the operating expenses of the special purpose vehicle and the coupon payments to the noteholders of the bond. In addition, fees payable to transactional agents such as the servicer of the assets, swap providers, providers of liquidity facilities, and others can be paid by utilizing some of the available excess spread. The deduction of these running costs for a transaction leads to the so-called base rate.
In addition to covering the transaction’s running costs, depending on the individual structure, these revenues can also be used to absorb eventual losses in the assets (e.g., defaults) or to cover shortfalls during asset liquidation.
Given the frequently changing nature of excess spread, it is therefore considered as dynamic credit enhancement, meaning that there can be some excess spread available, but equally it could disappear when needed most. Consequently, from an investor’s perspective, it is recommended to ignore excess spread for the purpose of calculating a transaction’s total credit enhancement, unless the excess spread is collected and trapped in the transaction’s reserve account. Dependent on the individual structure, the rating agencies also tend to ignore excess spread in their credit enhancement calculation.
From a performance analysis perspective, however, it is useful to know the level of excess spread produced by the underlying assets as this would usually indicate whether the assets are performing well and, hence, excess spread can serve as a key performance indicator (KPI) for the overall quality of the underlying assets, which directly impacts collateral performance.
5.6.3 External credit enhancement
Commonly used types of such external enhancement are guarantees, surety bonds, orletters of credit which are provided by a counterparty—sometimes referred to as a ‘‘credit enhancer’’—such as a bank, insurance company, or monoline insurer. This kind of guarantee can either apply to all tranches of a securitization or, more typically, only to one particular tranche. The rating of a guaranteed bond tranche is normally directly linked to the rating of the credit enhancer. As a consequence of the bond rating linkage to the counterparty rating, any rating action or volatility in the quality or performance of the credit enhancer may have a direct impact on the rating of the enhanced bond.