CFA Level I · CFA Level I Exam · Asset-Backed Security (ABS) Instrument and Market Features
Compared with internal credit enhancement, external credit enhancement in an ABS structure, such as a bond insurance guarantee from a third party, is most likely to:
External credit enhancement most likely introduces reliance on the guarantor's creditworthiness. Because a third party provides the support, a downgrade of that guarantor can weaken the ABS's rating. Tranching is an internal technique, and ratings are still required regardless of external support.
- Aintroduce reliance on the creditworthiness of the guarantorCorrect
- Breduce the issuer's need to rate the senior tranche
- Cbe created through tranching of the collateral pool
Explanation
External enhancement comes from a third party, so the securities' credit quality depends partly on the guarantor's credit standing; a downgrade of the guarantor can lead to downgrades of the ABS. Tranching, overcollateralization and reserves are internal. External enhancement does not remove the need for ratings.
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