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CFA Level I · CFA Level I Exam · Fixed-Income Securitization

In an ABS structure, the originator sells receivables to a special purpose entity that issues a senior tranche and a subordinated tranche. Losses are absorbed first by the subordinated tranche. This form of credit enhancement is most likely:

This is internal credit enhancement through subordination. Junior tranche holders absorb losses first, protecting the senior tranche, and the protection comes from the deal's own structure rather than from a third-party guarantee. Overcollateralization would instead involve collateral exceeding the face value of the bonds issued.

  1. Aan external credit enhancement, because it depends on a third-party guarantor
  2. Ban internal credit enhancement, achieved through subordinationCorrect
  3. Can internal credit enhancement, achieved through overcollateralization

Explanation

Subordination, or credit tranching, is an internal enhancement, since it is built into the deal structure and needs no third party. External enhancement involves a guarantee, surety bond or letter of credit from another party. Overcollateralization means collateral value exceeds the issued bonds, which is not what is described.

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