Fixed 215

Chapter 15
Asset-Backed
Securities
Copyright © 2016 Pearson Education, Inc.

15-1
Learning Objectives
After reading this chapter, you will understand
● how asset-backed securities are created
● the basic structure of a securitization
● the parties to a securitization
● the primary motivation for raising funds via a
securitization
● the role of the special purpose vehicle
● what a two-step securitization is
● the different types of structures: self liquidating and
revolving
● the various forms of credit enhancement

15-2
Learning Objectives (continued)
After reading this chapter, you will understand
● the different types of optional call provisions
● the structure of several major types of asset-backed
securities not backed by residential mortgage loans
● the credit risks associated with asset-backed securities and
how they are analyzed.
● the implications of the Dodd-Frank Wall Street Reform and
Consumer Protection Act for securitizations
● what is meant by a collateralized debt obligation,
collateralized bond obligation, and collateralized loan
obligation
● the structure of a collateralized debt obligation and the role
of the collateral manager

15-3
Creation of an ABS
v A security created by pooling loans other than mortgage
loans is referred to as an asset-backed security (ABS).
v To explain how an ABS is created and the parties to a
securitization, the textbook uses the following illustration.
→ Suppose that Exception Dental Equipment, Inc. has a bulk of
its sales from installment contracts (wherein the buyer
agrees to repay Exceptional Dental Equipment, Inc., over a
specified period of time for the amount borrowed plus
interest).
→ The dental equipment purchased is the collateral for the
loan. The credit department of Exceptional Dental
Equipment, Inc., makes the decision as to whether or not to
extend credit to a customer.

15-4
Creation of an ABS (continued)
→ The criteria for granting a loan are referred to as
underwriting standards.
→ Because Exceptional Dental Equipment, Inc., is granting the
loan, the company is referred to as the originator of the loan.
→ Moreover, Exceptional Dental Equipment, Inc., (EDE) may
have a department that is responsible for servicing the loan.
→ Servicing involves collecting payments from borrowers,
notifying borrowers who may be delinquent, and, when
necessary, recovering and disposing of the collateral (i.e., the
dental equipment in our illustration) if the borrower fails to
make the contractual loan payments.
→ Although the servicer of the loans need not be the originator
of the loans, in our illustration we are assuming that the
originator (EDE) is also the servicer.

15-5
→ Suppose EDE has more than $300 million of installment sales
contracts and wants to raise this amount. Rather than issuing
corporate bonds for $300 million, the EDE’s treasurer decides
to raise the funds via a securitization.
→ The criteria for granting a loan are referred to as underwriting
standards.
→ Because Exceptional Dental Equipment, Inc., is granting the
loan, the company is referred to as the originator of the loan.
→ To do this, EDE sets up a legal entity called a special purpose
vehicle (SPV) that is called DE Asset Trust (DEAT).
→ EDE will then sell to DEAT $300 million of the loans and so
receive from DEAT $300 million in cash, the amount of funds
it wanted to raise.
→ DEAT obtains the $300 million by selling securities that are
backed by the $300 million of loans.
→ The securities are asset-backed securities.

15-6
vParties to a Securitization
Ø In our hypothetical securitization, Exceptional Dental
Equipment, Inc. (EDE), is not the issuer of the ABS
(although it is sometimes referred to as the issuer
because it is the entity that ultimately raises the
funds).
ü Rather, it originated the loans.
ü Hence, in this transaction, EDE is called the “seller”
because it sold the receivables to DEAT.
ü EDE is also called the “originator” because it
originated the loans. DEAT (i.e., the SPV in the
securitization) is referred to as the “issuer” or “trust”
in the prospectus.

15-7
v Parties to a Securitization
Ø Although in our simple transaction EDE manufactured
the dental equipment and originated the loans, there is
another type of securitization transaction involving
another company (called a conduit) that buys the loans
and securitizes them.
ü A conduit that finances dental equipment manufactures would
warehouse the installment contracts purchased until it had a
sufficient amount to sell to an SPV, which would then issue
the ABS.
Ø There will be a trustee for the securities issued.
ü The responsibilities of the trustee are to represent the interests
of the bond classes by monitoring compliance with covenants
and in the event of default enforce remedies as specified in the
governing documents.

15-8
v Two-Step Securitization
Ø The previous description of the parties to a securitization is
referred to as a “one-step securitization.”
Ø For certain reasons that are not important to investors, a
securitization might involve two SPVs in order to ensure that the
transaction is considered a true sale for tax purposes.
Ø One SPV is called an intermediate SPV, which is a wholly owned
subsidiary of the originator and has restrictions on its activities.
Ø It is the intermediate SPV that purchases the assets from the
originator.
Ø The intermediate SPV then sells the assets to the SPV that issues
the asset-backed securities (i.e., the issuing entity).
Ø In the prospectus for a securitization transaction, the intermediate
SPV is referred to as the depositor.

15-9
vTransaction Structure
Ø In creating the various bond classes (or
tranches) in a securitization, there will be
rules for distribution of principal and interest.
Ø All asset-backed securities are credit
enhanced.
Ø Credit enhancement levels are determined
relative to a specific rating desired by the
seller/servicer for a security by each rating
agency.

15-10
vRole of the SPV
Ø To understand the role of the SPV, we need to
understand why a corporation would want to raise
funds via securitization rather than simply issue
corporate bonds.
Ø There are four principal reasons why a corporation
may elect to raise funds via a securitization rather than
a corporate bond:
1) potential to reduce funding costs
2) to diversify funding sources
3) to accelerate earnings for financial reporting purposes
4) to achieve (if a regulated entity) relief from capital
requirements

15-11
vRole the SPV
Ø Let us focus on the first of these reasons (e.g.,
potential to reduce funding costs) to see the critical
role of the SPV in a securitization.
→ Suppose that Exceptional Dental Equipment, Inc.
(EDE), has a BB credit rating.
→ If it wants to raise funds equal to $300 million by
issuing a corporate bond, its funding cost the going
rate for a firm with a BB credit rating.
→ If EDE defaults on any of its outstanding debt, the
creditors will go after all of its assets, including the
loans to its customers.

15-12
v Role the SPV
→ Suppose that EDE can create a legal entity and sell the
loans to that entity.
→ That entity is the special purpose vehicle (SPV).
→ In our illustration, the SPV is DEAT.
→ If the sale of the loans by EDE to DEAT is done
properly, DEAT then legally owns the receivables, not
EDE.
→ As a result, if EDE is ever forced into bankruptcy while
the loans sold to DEAT are still outstanding, the
creditors of EDE cannot recover the loans because they
are legally owned by DEAT.

15-13
vRole the SPV
→ The legal implication is that when DEAT issues the ABS that are backed
by the loans, investors contemplating the purchase of any bond class will
evaluate the credit risk associated with collecting the payments due on
the loans independent of the credit rating of EDE.
→ The credit rating will be assigned to the different bond classes created in
the securitization and will depend on how the rating agencies will
evaluate the credit risk based on the collateral (i.e., the loans).
→ In turn, this will depend on the credit enhancement for each bond class.
→ So, due to the SPV, quality of the collateral, and credit enhancement, a
corporation can raise funds via a securitization where some of the bond
classes have a credit rating better than the corporation seeking to raise
funds and that in the aggregate the funding cost is less than issuing
corporate bonds.

15-14
vCredit Enhancements
Ø We now review different forms of credit enhancement as
applied to nonagency MBS. They include structural,
originator-provided, and third-party provided credit
enhancement.
Ø External credit enhancement involves a guarantee from a
third party.
ü The risk faced by an investor is the potential for the third
party to be downgraded, and, as a result, the bond classes
guaranteed by the third party may be downgraded.
ü The most common form of external credit enhancement is
bond insurance and is referred to as a surety bond or a
wrap.

15-15
v Credit Enhancements
Ø Internal credit enhancements come in more complicated forms than
external credit enhancements and may alter the cash flow
characteristics of the loans even in the absence of default.
ü Most securitization transactions that employ internal credit
enhancements follow a predetermined schedule that prioritizes the
manner in which principal and interest generated by the underlying
collateral must be used.
ü This schedule, which is explained in the deal’s prospectus, is known as
the cash flow waterfall, or simply the waterfall.
ü The cash flows that remain after all of the scheduled periodic payment
obligations are met can be associated with the excess spread.
ü The excess spread is the first line of defense against collateral losses,
because deals that are structured to have a large amount of excess
spread can absorb relatively large levels of collateral losses.
ü The most common forms of internal credit enhancement are
senior/subordinate structures, overcollateralization, and reserve funds.

15-16
vOptional Clean-Up Call Provisions
Ø For ABS there is an optional clean-up call provision granted
to the trustee.
Ø Types of clean-up call provisions include:
1) percent of collateral call
2) percent of bond clean-up call
3) percent of tranche clean-up call
4) call on or after specified date
5) latter of percent or date call
6) auction call
7) insurer call
Ø The most common clean-up call provision is the percent of
collateral call where the outstanding bonds can be called at
par value if the outstanding collateral’s balance falls below
a predetermined percent of the original collateral’s balance.

15-17
Collateral Type and Securitization
Structure (continued)
v Structuring a securitization will depend on the
characteristics of the underlying assets.
v Two characteristics affect the structure:
1) amortization
2) interest rate
v The structure depends on whether
1) the assets are amortizing or nonamortizing
2) the interest rate on the collateral is fixed or
floating

15-18
v Amortizing Versus Nonamortizing Assets
Ø The collateral in a securitization can be classified
as either amortizing or nonamortizing assets.
Ø Amortizing assets are loans in which the
borrower’s periodic payment consists of scheduled
principal and interest payments over the life of the
loan.
ü The schedule for the repayment of the principal is
called an amortization schedule and can be created on
a pool level or a loan level.

15-19
vFixed-Rate Versus Floating-Rate Assets
Ø The assets that are securitized can have a fixed rate or a
floating rate.
ü The type of rate chosen impacts the structure in terms of
the coupon rate for the bonds issued.
ü For example, a structure with all floating-rate bond
classes backed by collateral consisting of only fixed-rate
contracts exposes bondholders to interest rate risk.
Ø To deal with situations where there may be a mismatch
between the cash flow characteristics of the asset and the
liabilities, interest rate derivative instruments are used in
a securitization.

15-20
Credit Risks Associated with
Investing in ABS
v Investors in ABS are exposed to credit risk and rely
on rating agencies to evaluate that risk for the bond
classes in a securitization.
v Although the three agencies have different
approaches in assigning credit ratings, they do focus
on the same areas of analysis.
v Moody’s, for example, investigates:
1) asset risks
2) structural risks
3) third parties to the structure

15-21
Investing in ABS (continued)
vAsset Risks
Ø Evaluating asset risks involves the analysis of the credit
quality of the collateral.
Ø The rating agencies will look at the underlying
borrower’s ability to pay and the borrower’s equity in the
asset.
Ø If there are a few borrowers in the pool that are
significant in size relative to the entire pool balance, this
diversification benefit can be lost, resulting in a higher
level of credit risk referred to as concentration risk.

15-22
vStructural Risks
Ø The decision on the structure is up to the seller. Once selected, the
rating agencies examine the extent to which the cash flow from the
collateral can satisfy all of the obligations of the bond classes in the
securitization.
Ø In reflecting on the structure, the rating agencies will consider
1) the loss allocation (how losses will be allocated among the bond
classes in the structure)
2) the cash flow allocation (i.e., the cash flow waterfall)
3) the interest rate spread between the interest earned on the collateral
and the interest paid to the bond classes plus the servicing fee,
4) the potential for a trigger event to occur that will cause the early
amortization of a deal (discussed later)
5) how credit enhancement may change over time.

15-23
vThird-Party Providers
Ø In a securitization, third parties who are involved include:
1) credit guarantors (most commonly bond insurers)
2) the servicer
3) a trustee, issuer’s counsel
4) a guaranteed investment contract provider (this entity insures
the reinvestment rate on investable funds)
5) accountants.
ü The rating agency will investigate all third-party
providers.
ü For the third-party guarantors, the rating agencies will
perform a credit analysis of their ability to pay.

15-24
vThird-Party Providers
Ø Although still viewed as a “third party” in many
securitizations, the servicer is likely to be the
originator of the loans used as the collateral.
Ø In addition to the administration of the loan
portfolio as just described, the servicer is
responsible for distributing the proceeds
collected from the borrowers to the different
bond classes in the structure according to the
cash flow waterfall.

15-25
vPotential Legal Challenges
Ø The long-standing view is that investors in ABS are
protected from the creditors of the seller of the
collateral.
ü That is, when the seller of the collateral transfers it to
the trust (the SPV), the transfer represents a “true
sale” and therefore in the case of the seller’s
bankruptcy, the bankruptcy court cannot penetrate the
trust to recover the collateral or cash flow from the
collateral.
ü However, this issue has never been fully tested.

15-26
Review of Several Major
Types of ABS (continued)
v The three largest sectors within the
ABS market are:
1) credit card receivable-backed
securities
2) auto loan-backed securities
3) rate reduction bonds

15-27
v Credit Card Receivable-Backed Securities
Ø Credit cards are issued by banks, retailers, and travel
and entertainment companies.
Ø The cash flow for a pool of credit card receivables
consists of finance charge collections, principal
collections, and fees collected.
Ø Credit card issuers have a large number of credit card
accounts that can be pledged to a trust.
Ø The process of structuring a transaction begins with the
credit card issuer setting up a trust and pledging those
credit card accounts to the trust.

15-28
Ø In credit card transactions, the type of trust used is
called a master trust and is referred to in the prospectus
as the trust portfolio.
Ø To be included as an account pledged to the master
trust, the account must meet certain eligibility
requirements.
Ø New credit card accounts can be pledged to the master
trust if they meet the eligibility requirements.
Ø If a credit card account in the master trust generates a
receivable, that receivable belongs to the master trust.

15-29
vCredit Card Receivable-Backed Securities
Ø Each series is a separate credit card deal and the
trust can issue bond classes to the public.
Ø For example, a series can have a senior bond class
and two subordinate bond classes.
Ø However, each series will have a different level of
credit enhancement.
Ø It is the cash flow from the trust portfolio that is
used to make the payments due to the bond classes
for all the series.

15-30
Ø Because a card receivable is a non-amortizing asset, it therefore has a
revolving structure.
Ø During the revolving period or lockout period, the principal payments
made by credit card borrowers comprising the pool are retained by the
trustee and reinvested in additional receivables to maintain the size of the
pool.
Ø The revolving period can vary from 18 months to 10 years. So, during the
revolving period, the cash flow that is paid out to the bond classes is
based on finance charges collected and fees.
Ø The revolving period is followed by the principal amortization period
where the principal received from the accounts is no longer reinvested but
paid to bondholders.
Ø There are various ways principal can be repaid over the principal
amortization period.

15-31
Review of Several Major Types of ABS
(continued)
Ø There are provisions in credit card receivable-backed securities that
require early amortization of the principal if certain events occur.
ü The events are referred to as pay-out events.
ü Such a provision, referred to as an early amortization provision or a rapid
amortization provision, is included to safeguard the credit quality of the
structure.
ü The only way that the principal cash flows can be altered is by occurrence of
a pay-out event.
Ø When early amortization occurs, the bond classes are retired sequentially
(i.e., highest rated bond class first, then the second highest rated bond
class, and so on).
ü This is accomplished by distributing the principal payments to the specified
bond class instead of using those payments to acquire more receivables.
ü The length of time until the return of principal is largely a function of the
monthly payment rate.

15-32
Review of Several Major Types of ABS (continued)
v Performance of the Portfolio of Receivables
Ø Interest to the bond classes is paid periodically (e.g.,
monthly, quarterly, or semiannually).
ü The interest rate may be fixed or floating.
ü A credit card receivable is a nonamortizing asset and
therefore has a revolving structure.
Ø There are provisions in credit card receivable-backed
securities that require early amortization of the principal
if certain events occur.
ü Such a provision, which is referred to as either an early
amortization provision or a rapid amortization provision, is
included to safeguard the credit quality of the structure.
ü The only way that the principal cash flows can be altered is
by triggering the early amortization provision.

15-33
(continued)
Ø The following concepts must be understood in
order to assess the performance of the portfolio of
receivables and the ability of the collateral to
satisfy the interest obligation and repay principal as
scheduled:
1) gross portfolio yield
2) charge-offs
3) net portfolio yield
4) delinquencies
5) monthly payment rate

15-34
(continued)
Ø The gross portfolio yield includes finance charges collected and
fees.
Ø Charge-offs represent the accounts charged off as uncollectible.
Ø Net portfolio yield is equal to gross portfolio yield minus charge-
offs.
Ø Delinquencies are the percentages of receivables that are past due
for a specified number of months, usually 30, 60, and 90 days.
ü They are considered an indicator of potential future charge-offs.
Ø The monthly payment rate (MPR) expresses the monthly payment
(which includes finance charges, fees, and any principal
repayment) of a credit card receivable portfolio as a percentage of
credit card debt outstanding in the previous month.

15-35
(continued)
v Auto Loan-Backed Securities
Ø Auto loan-backed securities are issued by the financial subsidiaries
of auto manufacturers (domestic and foreign), commercial banks,
and independent finance companies and small financial institutions
specializing in auto loans.
Ø The cash flow for auto loan-backed securities consists of regularly
scheduled monthly loan payments (interest and scheduled principal
repayments) and any prepayments.
Ø Prepayments for auto loan-backed securities are measured in terms
of the absolute prepayment speed (ABS).
Ø The ABS measure is the monthly prepayment expressed as a
percentage of the original collateral amount.
Ø The single-month mortality rate (SMM) is the monthly conditional
prepayment rate (CPR) based on the prior month’s balance.

15-36
(continued)
Ø Given the SMM (expressed as a decimal), the ABS
(expressed as a decimal) is obtained as follows:
ABS = S MM
1 + S MM ´ ( M – 1)
where M is the number of months after origination
(i.e., loan age).
Ø Given the ABS, the SMM is obtained as follows:
ABS
SMM =
1 – ( A B S [ M – 1])

15-37
(continued)
Ø Example. Suppose that the SMM is 2.1%, or 0.021, in
month 32. Then the ABS is
ABS = SMM =
1 + S M M ´ ( M – 1)
0.021 = 0.127 =1.27%
1 + 0 . 0 2 1 ´ ( 3 2 – 1)
Ø Example. Given the ABS just computed, the SMM is
obtained as follows:
ABS 0.015
S MM = = = 0.024 = 2.4%
1 – ( A B S [ M – 1]) 1 – ( 0 . 0 1 5[2 6 – 1])

15-38
(continued)
v Rate Reduction Bonds
Ø Rate reduction bonds are backed by a special charge (tariff)
included in the utility bills of utility customers in.
Ø The charge, called the competitive transition charge (or CTC), is
effectively a legislated asset.
Ø It is the result of the movement to make the electric utility industry
more competitive by deregulating the industry.
Ø The CTC is collected by the utility over a specific period of time.
Ø Because the state legislature designates the CTC to be a statutory
property right, it can be sold by a utility to an SPV and securitized.
Ø It is the legislative designation of the CTC as an asset that makes
rate reduction bonds different from the typical asset securitized.

15-39
(continued)
v Rate Reduction Bonds
Ø The CTC is initially calculated based on projections of
utility usage and the ability to collect revenues.
Ø However, actual collection experience may differ from
initial projections.
Ø Because of this, there is a “true-up” mechanism in these
securitizations.
Ø This mechanism permits the utility to recompute the CTC
on a periodic basis over the term of the securitization
based on actual collection experience.
Ø The advantage of the true-up mechanism to the bond
classes is that it provides cash flow stability as well as a
form of credit enhancement.

15-40
DODD-FRANK WALL STREET REFORM
AND CONSUMER PROTECTION ACT
v Because of the turmoil that occurred in the securitization market
and related sectors of the financial market, in July 2010,
Congress passed the Dodd-Frank Wall Street Reform and
Consumer Protection Act.
v The key features of the act that impact securitizations are
1) The requirement that “securitizers” retain a portion of the
transaction’s credit risk.
2) Requirements regarding reporting standards and disclosure for a
securitization transaction.
3) The representations and warranties required to be provided in
securitization transactions and the mechanisms for enforcing
them.
4) Due diligence requirements with respect to loans underlying
securitization transactions.

15-41
DODD-FRANK WALL STREET REFORM AND
CONSUMER PROTECTION ACT (continued)
v The specifics regarding how the above requirements should be
handled were not set forth in the act.
v With respect to nonagency RMBS, joint rules are to be specified
by the three federal banking agencies.
v The rules dealing with the amount and form of credit risk that
securitizers must retain differ for securitization that do not have
“qualified residential mortgages” and those that have entirely
such mortgages. For securitizations consisting entirely of
“qualified residential mortgages,” there are no risk retention
requirements.
v Securitizers that are required to retain credit risk are not
permitted to hedge (directly or indirectly) or transfer the credit
risk.

15-42
COLLATERALIZED DEBT OBLIGATIONS
v When the ABS market began, there was a debt product that
employed the securitization to pool a diversified pool of some asset
type and issue securities backed by the cash flow of the asset pool.
These debt products are called collateralized debt obligations
(CDOs).
v Although many types of asset classes have been used as collateral in
a CDO, the following are the major ones:
Ø investment-grade corporate bonds;
Ø high-yield corporate bonds;
Ø emerging market bonds;
Ø nonagency residential mortgage-backed securities (nonagency
RMBS);
Ø commercial mortgage-backed securities (CMBS);
Ø leveraged bank loans; and,
Ø collateralized debt obligations.

15-43
(continued)
v CDOs backed by investment-grade corporate bonds,

high-yield corporate bonds, and emerging market
bonds are referred to as collateralized bond
obligations.
v CDOs backed by nonagency RMBS and CMBS are
referred to as structured finance CDOs.
v CDOs backed by leveraged bank loans are called
collateralized loan obligations (CLOs).
v Finally, CDOs backed by bond classes of other CDOs
are referred to as CDO-squared or CDO.

15-44
(continued)
vStructure of a CDO
Ø In a CDO structure, there is a collateral manager responsible for
managing the portfolio of debt obligations.
ü The portfolio of debt obligations in which the collateral manager
invests is referred to as the collateral.
ü The individual issues held that comprise the collateral are
referred to as the collateral assets.
Ø The funds to purchase the collateral assets are obtained from the
issuance of debt obligations.
ü These debt obligations are referred to as tranches or bond
classes.
ü The tranches include: senior tranches, mezzanine tranches and
subordinate/equity tranches.

15-45
(continued)
vStructure of a CDO
Ø The ability of the collateral manager to make the
interest payments to the tranches and pay off the
tranches as they mature depends on the
performance of the collateral.
Ø The proceeds to meet the obligations to the CDO
tranches (interest and principal repayment) can
come from coupon interest payments from the
collateral assets, from maturing of collateral assets,
and from sale of collateral assets.

15-46
(continued)
vStructure of a CDO
Ø In a typical structure, one or more of the tranches has a
floating rate. With the exception of deals backed by bank
loans that pay a floating rate, the collateral manager invests
in fixed-rate bonds.
Ø The collateral manager must monitor the collateral to
ensure that certain tests are being met. There are two types
of tests imposed by rating agencies: quality tests and
coverage tests. In rating a transaction, the rating agencies
are concerned with the diversity of the assets.
Consequently, there are tests that relate to the diversity of
the assets. These tests are called quality tests.

15-47
(continued)
vDistribution Rules
Ø There are three relevant periods.
1) The first is the ramp-up period.
ü This is the period that follows the closing date of the
transaction where the collateral manager begins investing
the proceeds from the sale of the debt obligations issued.
ü This period usually lasts from one to two years.
2) The reinvestment period or revolving period is where
principal proceeds are reinvested and is usually for five or
more years.
3) In the final period, the collateral is sold and the
debtholders are paid off.

15-48
(continued)
vDistribution Rules
Ø Income is derived from interest income from the collateral
assets and capital appreciation.
Ø The income is then used as follows.
ü Payments are first made to the trustee and administrators
and then to the senior collateral manager.
ü Once these fees are paid, then the senior tranches are paid
their interest.
ü At this point, before any other payments are made, certain
tests must be passed.
• These tests are called coverage tests.

15-49
(continued)
vDistribution Rules
Ø The principal cash flow is distributed as follows after
the payment of the fees to the trustees, administrators,
and senior managers.
Ø If there is a shortfall in interest paid to the senior
tranches, principal proceeds are used to make up the
shortfall.
Ø After all the debt obligations are satisfied in full, if
permissible, the equity investors are paid.
Ø Typically, there are also incentive fees paid to
management based on performance.

15-50
Key Points
● Asset-backed securities are created by pooling loans and
receivables through a process known as securitization.
● The main parties to a securitization are the seller/originator
(party seeking to raise funds), special purpose vehicle, and
servicer.
● The motivation for issuing asset-backed securities rather
than issuing a corporate bond is the potential reduction in
funding cost. The key to this savings is the role of the special
purpose vehicle.
● ABS are credit enhanced to provide greater protection to
bond classes against defaults. There are two general types of
credit enhancement structures: internal and external.

15-51
Key Points (continued)
● Internal credit enhancements include structural credit
enhancement (senior/subordinate structures) and
originator-provided credit enhancement (cash reserves,
excess spread, and overcollateralization).
● External credit enhancements come in the form of third-
party guarantees, the most common historically being
bond insurance which is no longer used in deal’s since
2007.
● In analyzing credit risk, the rating agencies will examine
asset risks, structural risks, and third parties to the
structure. Based on this analysis, a rating agency will
determine the amount of credit enhancement needed for a
bond class to receive a specific credit rating.

15-52

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Chapter 15

Copyright © 2016 Pearson Education, Inc.

Copyright © 2016 Pearson Education, Inc.

Copyright © 2016 Pearson Education, Inc.

Copyright © 2016 Pearson Education, Inc.

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Copyright © 2016 Pearson Education, Inc.

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