Credit enhancement is a risk reduction technique used to protect investors against loss in the underlying security or debt instrument. Methods include over-collateralization, insurance policies, and subordinated bonds. It is an integral part of securitization and structured financing, but not allowed in some countries. Some companies offer credit enhancements to individual consumers, but caution is advised.
In financial terms, credit enhancement is the use of a risk reduction technique to protect an investor against loss in the underlying security or debt instrument. In banking terms, credit enhancement is any technique used to improve the credit rating of an asset-backed security or bond to improve marketability. These methods are often used in both public and private project financing, and as an integral part of structured financing.
There are several legitimate methods that can improve the financial stability of a debt instrument. One method is over-collateralization. Collateral is property that is pledged as security for a debt. A common example is a mortgage. If a person defaults on the loan, the mortgage holder has the right to seize the property as repayment of the loan through the foreclosure process.
If a company wishes to issue bonds or another form of debt instrument, it may pledge assets held as security for the debt. Typically, the assets pledged would equal the amount borrowed. If the company wants to improve the credit rating of its bonds or notes, it can commit assets with a value greater than the amount of the obligation. For example, if a company wants to issue $250,000 US dollars (USD) in bonds and pledges $275,000 worth of assets, it is using the over-collateralization credit enhancement technique. The risk to the investor is greatly reduced, as there are more than enough properties pledged to pay off the debt in the event of a default.
Another credit enhancement technique is the use of special insurance policies or letters of credit issued by banks. These policies or letters guarantee full repayment of the debt instrument in the event of default by the issuer. Insurance policies are commonly used for projects financed by municipal bonds. The cost of acquiring the insurance or letter of credit results in a somewhat reduced yield on the bonds, however they are much more marketable due to the lower risk involved with the investor.
Credit enhancement is an integral part of securitization, a form of structured financing that turns an illiquid asset into a more liquid security. The most common are Mortgage-Backed Securities (MBS) or Asset-Based Securities (ABS). These group a series of financial assets, such as mortgages, bonds, debt instruments, credit-linked notes or accounts receivable from rental properties or credit card obligations. Bonds are issued to investors in the pool of assets, and the proceeds from those assets pay for the bonds.
The credit rating of an MBS or ABS is enhanced through the issuance of subordinated bonds. Subordination is a tiered classification method that defines which debts will be paid first and which will be paid last. The bonds that will be paid off first are called senior bonds and have the highest credit rating because they carry less risk if the income stream slows. The junior notes, which are the last to be paid, are subordinated to the senior notes. They will have a lower credit rating because they carry more risk.
The use of structured finance is not allowed in many countries that are based on civil law and do not have trust laws. This is true in many Latin American countries. Some of the companies in those countries, however, use this method to raise capital for expansion and development projects. In those areas, the process must be handled offshore.
There are a number of companies that also offer credit enhancements to individual consumers. While some of the techniques used by these companies are legitimate, a consumer should be very careful. Some companies “enhance” credit simply by adding the person’s name to a credit card account owned by an unrelated party with excellent credit. If this is done simply to help someone qualify for a loan that they would not qualify for on their own, the practice could be considered fraudulent under some banking laws.
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