Internal and External Credit Enhancements

A __credit enhancement__ makes a bond safer. These include __internal credit enhancements__, which are things the firm can take care of in how it structures the debt itself, or also __external credit enhancements__, which is how the firm can lean on a third-party to provide some assurance to investors by acting as a backup source of funds.

No, nothing is free. This guarantee has a cost for the guarantor, so the principal would certainly see this cost passed along.

No, while it is true that there would be a cost, there should also be a reason why the credit enhancement is "purchased."

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How would you think about the relative cost to a principal of an external credit enhancement?

One popular internal credit enhancement is the process of __subordination__. The bond issue is separated into various __tranches__ of debt from senior to junior. This provides protection for the senior tranches, since it will be paid in full in case of liquidation. After that, the second tranche will receive payment. Finally, the lowest, or most junior tranche, will obtain repayment of what is left. This works like a waterfall coming down a rocky cliff. If the highest pool is filled, water will flow down to lower pools until it runs out. Maybe there will be some water left at the very bottom, and maybe not. This is why the subordination structure is often called a "waterfall structure," since it works exactly this way.

Suppose a bond issue is separated into three tranches using the waterfall structure, and the middle tranche receives 80% repayment in liquidation. What would you assume to be the repayment of the other two tranches?

No, the senior tranche should receive 100% repayment.

Exactly! The senior tranche will be paid in full before the middle tranche receives anything. But if the middle tranche gets just 80% repayment, then there won't be anything left for the most junior tranche. They are out of luck.

No, that's not the meaning of the waterfall structure. Seniority is important here, so the senior tranche will receive much more than the junior tranche.

A second method of internal credit enhancement is overcollateralization. This is where bonds with a total principal of $50 million might be backed by receivables totaling $60 million. This looks really safe at first glance, but of course it also assumes there won't be more than a 20% default rate, since that would wipe out the $10 million "buffer." This is exactly what happened during the housing bust in 2007-2008, when mortgage-backed securities were overcollateralized, but with some really bad quality mortgages. The buffer wasn't enough. Housing prices fell, and many were soon valued less than the mortgage, increasing the default rates beyond what was expected.

How would you best state the lessons learned from this failure in overcollateralization?

No, it can work just fine, if some other assumptions are met.

Absolutely! This crisis started when assets turned out to be backed by junk assets instead of high-quality loans, as investors thought. The quality of the collateral was grossly misunderstood.

No, the rate of overcollateralization isn't as important as the quality of the collateral used.

__External credit enhancements__ allow the firm, known here as the principal, to lean on a third-party to provide some assurance to investors by acting as a backup source of funds. This third party is called the guarantor. Examples of external credit enhancements include letters of credit and bank guarantees. These aren't as common as it used to be, since banks who were providing these letters of credit suffered from ratings downgrades in recent years.

Exactly! That's the tradeoff. The principal would pay some small percentage of principal in order to have this credit enhancement, but then this allows them access to lower-cost debt. These credit enhancements expose the investor to counterparty risk. There is always some chance that these third-party assurances won't pan out. This is why a "cash collateral account", where the issuer borrows the collateral and leaves it safely invested, is always safer for investors instead of just a promise of cash conditional upon default.

A third internal credit enhancement is __excess spread__. With this method, the payment to investors is planned as less than the payments received from the backing issue. This difference is saved in a reserve account as a line of protection against default.

It would cost the principal nothing

It would cost the principal something, making it always a bad deal

It would cost the principal something, but save the principal in cost of debt

The most senior tranche should receive approximately 90% repayment, and the most junior tranche will get less than 80% repayment

The most senior tranche will receive 100% repayment, and the most junior tranche should get nothing

Since it's a waterfall structure, money should flow to both the most senior and most junior tranches in the same 80% repayment rate

Overcollateralization doesn't work

The quality of collateral is still important, even with overcollateralization

Any overcollateralization should have at least 150% asset backing of an issue

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