The amount or size of credit enhancement needed to obtain a specific credit rating is specified by the rating agencies from which a rating is sought. A rating agency does the sizing of the credit enhancement and the structurer determines the best mix of credit enhancements to achieve the amount specified by the rating agency. The factors considered by rating agencies in sizing a transaction are (1) the obligor’s incentives to default; (2) the credit quality of the obligors; (3) the likely loss scenario and the potential variability of loss; and (4) the diversification of the asset pool.²⁹

The credit enhancement level for every bond class in a structure to be rated is based on the target rating sought for that bond class. For instance, for a rating agency to award a triple-B rating to a bond class, the probability of any losses in the portfolio impacting the triple-B bond class must not be more than the standard historical probability of a triple-B rated investment defaulting. The probability of loss has to be lower the higher the target rating sought for a bond class; hence, a higher level of credit enhancement is required for a higher target rating.

In this chapter, we discuss the various credit enhancement mechanisms and how the needed credit enhancement for a transaction is sized.