Credit Enhancement and Rating of Securitized Assets

Understand Credit Enhancement and Rating of Securitized Assets

Key rules to remember

Over-collateralisation amount

Over-collateralisation = Pool value − Face value of securities issued

Express as a % of pool value or of securities issued. Say which base you use.

Credit enhancement as % of pool

Credit enhancement % = (Pool value − Senior securities) ÷ Pool value × 100

Everything junior to the senior tranche, including over-collateralisation, forms the cushion for it.

Loss absorption order

Pool loss is absorbed by: excess spread / reserve → junior tranche → mezzanine → senior

Exact order depends on the deal waterfall. State your assumption.

Excess spread

Excess spread = Interest collected on pool − (Coupon on securities + servicing and other costs)

Compute per year. It is the first line of defence in many deals.

Cover multiple

Cover multiple = Credit enhancement available ÷ Expected loss

A higher multiple supports a higher rating. Do not quote a fixed multiple for a rating unless the question gives it.

How to solve Credit Enhancement and Rating of Securitized Assets questions

1. 1Read the data: pool size, securities issued by class, interest rates, expected loss or default rate, reserves and any guarantee.
2. 2Identify the enhancement type in the question: internal (tranching, over-collateralisation, excess spread, reserve) or external (guarantee, insurance).
3. 3Compute the cushion: pool value minus the senior tranche, or the amount of each junior layer, as a percentage of the pool.
4. 4Apply the loss in waterfall order: first excess spread or reserve if given, then junior, then mezzanine, then senior. Show the balance left at each layer.
5. 5Compare enhancement with expected or stressed loss and state the cover multiple or whether the tranche is wiped out.
6. 6Link to rating: more cover over stressed loss supports a higher rating. Mention pool quality, originator and legal structure where the question asks about rating.
7. 7Conclude clearly: which tranche is safe, what enhancement is needed, or what you recommend.

Quickest way: Layer-by-layer loss table

Common mistakes in Credit Enhancement and Rating of Securitized Assets

• Treating over-collateralisation and tranching as the same thing.

  Both create a loss buffer.

  Fix: Over-collateralisation is extra pool value over securities. Tranching is a split of securities by seniority. Explain them separately.

• Taking the cushion as a percentage of the wrong base.

  Pool value and securities issued differ when there is over-collateralisation.

  Fix: Use pool value as the base unless the question says otherwise, and state it.

• Letting the senior tranche absorb loss before the junior tranche.

  Students share the loss proportionately.

  Fix: Losses go to the junior tranche first. The senior tranche loses only after all layers below are exhausted.

• Saying the rating is a rating of the originator.

  Confusing issuer rating with instrument rating.

  Fix: The rating is of the securitized instrument and depends on pool quality and enhancement, not on the originator's own rating alone.

• Ignoring that external enhancement adds guarantor risk.

  Guarantees look purely positive.

  Fix: Note that the rating depends on the guarantor's strength and can fall if the guarantor is downgraded.

• Writing only definitions in a 14-mark answer.

  Recall is easier than application.

  Fix: Add figures, the waterfall and a conclusion on which tranche or rating is supported.

Worked examples