If the excess spread is not paid to the originator/seller either up-front ³⁰ or over a specified period, it is retained by the SPV in a spread account. When it retained in a spread account, the excess spread is said to be “trapped.” The advantage of retaining the excess spread is that it can be used to offset losses in future periods. In contrast, if the excess spread is distributed to the originator/seller, it can only be used to protect against losses in the current period. The structure might provide for withdrawal of the retained spread either (1) on a periodic basis; (2) after the last liability is paid off; or (3) after the retained cash builds a reserve of a particular amount.³¹

In every structure, there should be sufficient excess spread at least to absorb the expected losses. Credit enhancement goes further by providing for unexpected losses as well. If things turn bad and the losses exceed the expected loss level, will there be a default on the outstanding classes? Credit enhancement, consistent with the rating of the transaction, indicates the ability of the structure to withstand unexpected losses.

Because the excess spread cannot be relied upon as a definitive source of support, it is referred to as soft credit enhancement. Due to changes in the asset pool over time, the dollar amount of the excess spread varies over time; therefore, one cannot measure the excess spread as a percentage of the total liabilities of the structure at the inception of the transaction. Nor can excess spread be measured as a percentage of the outstanding asset balance. A reduction in excess spread over time may arise as a result of prepayments and defaults. A major concern is that the better quality obligors in the asset pool prepay and exit the asset pool, leaving only the low credit quality obligors. As a result, this increases the credit risk of the structure. Moreover, within an asset pool there are low-spread contracts and high-spread contracts. Faster prepayments of the latter contracts will reduce the amount of future excess spread (i.e., reduce the weighted average spread of the collateral).

Rating agencies are well aware that the excess spread is soft in that it cannot be relied upon as a form of excess spread. Consequently, in giving allowance for the amount of the credit enhancement needed to obtain a target rating, rating agencies will not give a dollar-for-dollar allowance. Rather, in its modeling of the structure, it will penalize the credit enhancement based on the target rating. For example, suppose a securitizer is seeking a triple-B rating for a bond class. The rating agency might in its modeling of the structure give an 85% allowance for the excess spread in computing the credit enhancement. In contrast, if a triple-A rating is sought for a bond class, the same rating agency might only give a 40% allowance. The lower allowance is due to the risk that we just described: prepayments and defaults, particularly on high spread contracts.

First, the originator/seller can create a cash collateral account at the initiation of the transaction and the cash in that account is subject to withdrawal in the event of losses that exceed the amount provided by other forms of credit enhancement. At the termination of the transaction, any balance in the cash collateral account is returned to the originator/seller.

Second, the originator/seller can make a subordinated loan to the SPV. Both the cash collateral payment at inception and the subordinated loan are referred to as hard credit enhancement because the amount of the credit enhancement is known.

The third form of cash collateral is the retention of the excess spread discussed earlier.

While cash is the best form of credit enhancement, retention of cash leads to a problem of negative carry. The so-called cash collateral is actually reinvested in some passive financial assets of a very high quality—hence, obviously at very low rates of return. Because the rate of return is less than the coupon rates paid to investors, the result is holding assets in cash form that leads to losses.

From the originator/seller perspective, the extra $40 million (i.e., the overcollateralization) transferred to the SPV is a transfer for the sake of security, not a legal transfer. From an accounting perspective, the overcollateralization is treated as a deposit for security, not a transfer of ownership.

As a form of credit support, overcollateralization differs from cash collateral in four noteworthy ways. First, because overcollateralization results in a collateral in kind, while cash collateralization results in a collateral in cash, the negative carry problem inherent in cash collateral does not apply to overcollateralization. Second, if it assumed that the cash collateral is invested for a fixed time, the percentage size of the cash collateral increases over time as the pool is paid down. In contrast, over time the percentage size of overcollateralization does not increase because the size of the overcollateralized assets also simultaneously declines. Third, with overcollateralization there is both excess interest and excess principal in the structure because the principal is collected on assets worth more than the liabilities. Finally, excess spread is not reduced as a result of overcollateralization because the in-kind assets generally have the same note rate as the other assets in the pool. In the case of cash reserve, the rate of return that can be earned on the cash can be significantly less than the coupon payable on the bond classes.

When there is overcollateralization, there may be early amortization triggers. These provisions provide that if the performance of the pool worsens as gauged by the one or more specified tests, then instead of the subordinated interest in the principal being paid off to the originator/seller, the principal is redirected to pay off the other bond classes.

The meaning of senior-subordinate structure is similar to the prioritization of claims in corporate funding—senior secured debt has a prior claim over unsecured debt, while the latter has a prior claim over subordinated debt, preferred stock or equity. In the same way, senior noteholders have a prior claim over the cash flows and the junior liabilities will pick up the losses first until they survive. Because the senior bond classes have the lowest credit risk in the structure, they are offered the lowest spread to Treasuries. The subordinated bond classes are those that have subordinated claims on the assets. Just like equity holders, investors in these bond classes stand a greater probability of realizing a loss of principal and interest. For a given duration or average life, the spread to Treasuries increases as one goes down the ladder of the liabilities.

In terms of ratings, as explained in Chapter 4, the stratification of liabilities is done so as to have a triple-A rating awarded for the senior-most bond class. The rating for the juniormost-rated bond class is what is sellable in the market. The unrated class is typically retained by the originator.

It is important to note that third-party credit enhancements are subject to third-party credit risk. This is the risk that the third-party guarantor may be either downgraded and, depending on the performance of the asset pool, the bond classes guaranteed made be downgraded, or the third-party may be unable to satisfy its commitment. In addition, third-party enhancements are a cost to the transaction.

In securitization transactions, a financial guarantee is employed to credit enhance a bond class in a structure to the investment-grade level of the insurer. Basically, regardless of the performance of the asset pool, a financial guarantee (also referred to as a surety bond or bond insurance) guarantees that the investors in the bond classes covered by the policy receive timely payment of principal and interest. ³² In addition to their use for providing credit enhancement for long-term assets such mortgage loans, financial guarantees have been a particularly important form of credit enhancement both for new asset classes that have been securitized and for novel structures.

In the U.S. asset-backed securities market, as of early 2008 the major monoline insurance companies were Ambac Assurance Corporation, Financial Guaranty Insurance Company (FGIC), Financial Security Assurance (FSA), and MBIA.³³ These insurers have also been responsible for insuring a significant amount of asset-backed securities outside the United States. There are major concerns with the credit risk of monoline insurers as highlighted by the subprime mortgage meltdown and its impact on these insurers.

The use of a LOC as a credit enhancement vehicle has declined since they are obtained from top-rated banks but the number of such banks has declined. Moreover, due to risk-based capital requirements, the economic benefit for banks to issue a LOC has declined. Hence, LOCs have become a more costly form of credit enhancement.