Document I

What Credit Enhancement Is

Credit enhancement is any arrangement that makes a debt obligation safer for whoever holds it than the bare promise of the borrower alone. The phrase covers a family of small, concrete mechanisms rather than a single product: extra collateral, ordered losses, held-back cash, and outside promises. Each mechanism has a document behind it, and each can be read in a few minutes once its purpose is plain.

The clearest way to read any support is from the lender’s chair. A lender holding a promise to pay asks three questions. If payments stop, what do I take? Who absorbs losses before I do? And whose promise, other than the borrower’s, can I call on? Every mechanism in these notes is an answer to one of those three questions, and nothing in the subject is more complicated than keeping track of which question a given support answers.

Supports exist because promises are priced. A stronger promise sells at a lower yield, reaches buyers whose own rules would otherwise keep them out of the paper, and stays sellable in weeks when unsupported paper is not. For the borrower, the cost of arranging a support is weighed against the interest saved; for the holder, the support is the difference between owning a story and owning a schedule.

The first family is internal. Internal supports are built into the structure of the deal itself and paid for out of the deal’s own assets and cash flow. Overcollateralization pledges more collateral than debt. Subordination orders the investors so that junior classes take losses first. Excess spread holds the deal’s interest margin as a running cushion. Reserve accounts set cash aside on day one. These are the subject of Document II.

The second family is external. External supports are purchased from a party outside the deal: a bank’s letter of credit, a surety bond, a parent or third-party guarantee, or cash collateral placed with an independent institution. Their strength is that fresh money stands behind the borrower; their weakness is that the holder now also depends on the provider’s own condition. These are the subject of Document III.

One caution belongs in the first document rather than the last. No support makes a bad pool good. Enhancement redistributes loss; it does not abolish it. When losses run past the cushion, they arrive at the senior holder anyway, and the years before that point can make the cushion look sturdier than it is. The discipline of the subject is in sizing the support against honest expectations, not in the existence of the support itself.

At a glance

• Internal supports are built into the deal: overcollateralization, subordination, excess spread, reserve accounts.
• External supports are purchased from outside: letters of credit, surety bonds, guarantees, cash collateral.
• Every support answers one of three questions: what do I take, who loses first, whose promise can I call on.
• Enhancement redistributes loss between parties; it never abolishes the loss itself.

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