Credit Enhancement

Credit Enhancement

Credit Enhancement
internal	Excess servicing spread funds (a type of reserve fund) Overcollateralization
external	Letters of credit Bond insurance

Credit Enhancement

	Credit Card Receivable ABS
Excess servicing spread	The ABS issuer pays a coupon to investors that is less than the coupon earned on the collateral. The excess of cash inflows over cash outflows is used to fund credit losses in the collateral.
Letter of credit	A letter of credit is a third party, usually a bank, guarantee against collateral losses up to a certain point. Defaults on the collateral are thus mitigated to a certain extent. The third-party guarantees are subject to the weak-link philosophy and any credit downgrades associated with the third party will negatively affect the rating of the ABS.
Overcollateralization	Total principal of collateral > Total principal of tranches (Total principal of collateral - Total principal of tranches) = extra collateral When (Total principal of collateral - Total principal of tranches) < 0, collateral defaut would first be absorbed by the extra collateral. Then losses from defaults (a credit event) are absorbed by subordinated tranche until the principal backing the tranche is exhausted. Home equity loan ABS.