Credit Enhancements

In addition to the distinct asset pools supporting the interest and principal payments owned to investors who have purchased the debt instrument, there are a number of structural features that can be included in the transaction to enhance the credit and likelihood of making timely payments.

Overcollateralization

The primary credit enhancement is most securitizations is having a larger distinct pool of assets than what is required to service the debt instrument. For example, if the distinct pool of assets contains loans with a face value of $1.25 million and the principal outstanding on the debt instrument purchased by investors equals $1 million, then there is an additional $250,000 of assets in the distinct pool available to satisfy the $1 million outstanding. This would equate to a 25% over collateralization ($250,000 / $1,000,000). The inverse of overcollateralization is often cited as well in securitizations and is called an advance rate. In this example the advance rate would equal 80% ($1,000,000 / $1,250,000). The advance rate can also be referred to as loan to value ("LTV"), although this term is typically reserved for underlying loans and not generally cited in securitizations.

Cash Reserve

Another common credit enhancement found in many securitization is having a side pocket of cash held in a bank account for the benefit of investors who have purchased the debt instrument to cover any underperformance from the distinct asset pool. Following with our example, if the $1,000,000 principal value of the debt instrument also had the benefit of a $100,000 cash reserve, then that would provide additional cushion to service interest and principal payments on the debt instrument. This would equate to a 10% cash reserve. The cash reserve is generally funded by the proceeds of the debt instrument itself. In this example, if the $1,000,000 debt instrument was issued on January 31, 2022, $900,000 of proceeds less transaction expenses would be wired to the originator and/or its SPV and $100,000 would be withheld in account not accessible by the originator and/or its SPV.

Excess Spread

The distinct asset pool generating cash flows is typically comprised of a diverse array of underling loans, advances, receivables or other credit products. Each of these underlying assets will carry a rate of return and, in aggregate, will generate a pool-level return net of defaults and losses. The debt instrument offered to investors will also carry a stated rate of return. The difference between the portfolio-level net return and that return owed to investors of the debt instrument is the excess spread and offers an additional credit enhancement to the securitization. For example, if the underlying pool of assets returns in aggregate 15% APY and the debt instrument is required to pay investors a 10% coupon, this would equate to a 5% excess spread.

Credit Insurance

Some securitizations issuers, underwriters and investors opt to seek credit insurance on the debt instrument. There are a number of regulated insurance companies in the United States that offer credit insurance. These coverages typically cover a set percentage in the event of a default, and the payouts are provided by the insurance companies. Therefore, the risk of non-payment from the securitization structure is replaced with the risk of non-payment from a typically investment-grade rated insurance company with a strong balance sheet able to withstand potential defaults.