Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-

Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-

ance or a letter of credit. In this form of credit enhancement, an insur- ance provider agrees, for a fee, to guarantee the performance of a certain amount of the collateral against defaults. If, for example, a loan in the collateral pool goes into default and the underlying collateral is repossessed and then sold at a loss resulting in a partial payoff of the outstanding loan balance, the bondholders would be in a position not to recover the principal outstanding for that loan. To provide protection to the bondholders, an insurance provider will pay the difference between the loan payoff amount and the amount due to the bondholders, thereby absorbing the loss.

Borrowing Via Structured Finance Transactions

The rating agencies decide on the creditworthiness of the insurance provider to determine the credit rating of the bonds. Perhaps the biggest perceived disadvantage to this form of credit enhancement is so called event risk. Triple A rated bondholders, for example, can enjoy triple A status only as long as the enhancement provider retains its triple A credit rating status. If the credit enhancement provider is downgraded (i.e., its credit rating is lowered by a rating agency), the bonds guaran- teed by the enhancement provider are typically downgraded as well.

Overcollateralization One form of internal credit enhancement is overcollateralization. In this

form of credit protection, credit enhancement is provided by issuing bonds with a par value that is less than the par value of the loans or receivables in the collateral pool. For example, if there are $200 million of loans in a collateral pool and the issuer wanted to use overcollateral- ization for credit enhancement to achieve, say, a triple A credit rating for the bonds to be issued, the issuer would obtain from the rating agen- cies an indication as to how many bonds it could issue versus the $200 million par value of loans in the collateral pool to obtain the target credit rating. Depending on the characteristics of the loans and their perceived creditworthiness, the rating agencies might allow $190 mil- lion of par value of bonds to be issued.

This means that cash flows for $200 million par value of loans is available to bondholders but only $190 million par value of bonds need to be paid interest and principal. The cash flows from the extra $10 mil- lion of loans can either flow into a “reserve account” where the flows are reserved until such a time as they are needed to cover losses or the funds are used to retire bonds early. If a $3 million loss is realized by the collateral pool, there will still be enough cash flow from the other loans to insure that the triple A rated bonds receive their payments. After all the bonds have been retired, the remaining funds in the reserve account and any remaining collateral are distributed to the originator (assuming the originator has not sold its interest in the collateral).

The cost of such an arrangement is implicit in the price paid for $200 million par value of collateral versus the proceeds of issuing only $190 million par value of bonds.