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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

An investor holds a tranche of an auto-loan ABS in which the sponsor's excess spread, after paying coupons and fees, is trapped in a reserve account until a target level is reached. What is the main purpose of this feature?

Trapping excess spread in a reserve account is internal credit enhancement. The cash cushion absorbs early collateral losses before noteholders are affected, thereby supporting the credit quality of the ABS tranches without changing the structure or making it synthetic.

  1. ATo provide internal credit enhancement that absorbs early losses before investors in the notesCorrect
  2. BTo transfer prepayment risk from the senior to the equity tranche
  3. CTo remove the need for a special purpose vehicle
  4. DTo convert the ABS into a synthetic structure using credit default swaps

Explanation

Excess spread is the difference between collateral interest and the costs of the notes and fees. Trapping it in a reserve account builds internal credit enhancement that covers losses first. It does not alter the legal structure or convert the deal to synthetic.

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