Lesson 2 of 6 · 15 min
Credit enhancement: OC, excess spread and tranching
Securitizations protect bondholders from defaults in the pool with extra collateral, extra interest and a loss waterfall in which junior tranches are wiped out before senior ones lose anything.
In short
- Credit enhancement: financial support that absorbs losses from defaults on the underlying loans.
- Three main internal enhancements: overcollateralization (pool value > bonds' face value), excess spread (collateral coupon − coupon paid on the securities) and subordination (credit tranching).
- External enhancements come from third parties: bank or insurer financial guarantees, letters of credit and cash collateral accounts.
- In a senior/subordinated (waterfall) structure, the most junior tranche absorbs losses first; the senior tranche loses only once every class below it is wiped out.
- Each tranche is rated on the quality of the collateral and its own seniority, so a senior tranche can be rated above the company that originated the loans.
Unlock this lesson free for 7 days
Create a free account to get 7 days of full access — every lesson, video, flashcard, mock and the question bank. No card needed.