A Brief Guide To Credit Enhancement

Posted by: TheGuarantors on October 19, 2021

Building credit is a crucial step in securing your future. It can be frustrating if you’re hitting walls with understanding the technical jargon around this concept. This blog aims at dissecting the types of credit enhancement and gives an overview of how you can improve your credit score. Let's dive in!

Credit enhancements are provisions that a borrower or a bond issuer can use to reduce a bond issue or debt by improving its creditworthiness. This process depresses the credit risk that comes with the debt, increasing the overall credit rating or credit score while providing reasonable and required security to the lender, plus lowering interest rates.

They are very often used when creating asset-backed security (ABS), mortgage-backed securities, collateralized debt obligations, and collateralized bond obligations. There are several internal and external ways of enhancing creditworthiness discussed here in the context of an ABS.

There are two primary types of credit enhancements; internal and external. Internal enhancements are built into the structure of the bond issue while a third party provides external enhancements.

Credit Enhancement Process

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1. Internal Credit Enhancements

Subordination

Subordination is a method where a bond issue is divided into tranches or parts with different priorities to claims. Cash flow generated by underlying assets first goes to full-filling the needs of the most senior bonds, then to the following highest priority bonds, and so forth. Hence, this is sometimes referred to as a waterfall structure.

Over-collateralization

Over-collateralization occurs when the pledged collateral has a value greater than the power value or security of the debt issued. Losses are absorbed by the extra collateral.

For example, suppose the principal amount of bond allocated is 10 million dollars, and the collateral value is 11 million. In that case, the amount of over-collateralization is 1 million; however, the amount of over-collateralization changes with time. For instance, if collateral pledged is a property, the amount of over-collateralization will fluctuate due to changing valuations of the property.

Reserve Accounts

Reserve accounts can come in two forms, a cash reserve fund and an excess spread account. A deposit of cash to absorb loss is a cash reserve fund. Suppose the cash flow from the asset is insufficient to meet the promised payments. In that case, the cash flow from the account can be used to top up the difference with an excess spread account.

2. External Credit Enhancements

They include surety bonds, bank guarantees, letters of credit from financial institutions, and cash collateral account.

Surety Bonds and Bank Guarantee

Insurance companies provide surety bonds, while bank guarantees are from banks. Both of them serve the same function; they assure to make up any shortfall in cash available to provide the debt. Suppose the expected cash flow and obligation to the debt holders are 10 million dollars. Still, the actual cash flow is only 7 million dollars. In that case, the insurance company or bank will have to top up the shortfall of 3 million dollars.

Letter of Credit

A letter of credit works under similar circumstances. This is a promise to lend the shortfall amount to the issuing entity instead of paying out the amount.

While all three of these external credit enhancements increase the credit quality of the debt issues and decrease their yields, deterioration of the credit quality of the guarantor will also reduce the credit quality of the covered issue.

Cash Collateral Account (CCA)

CCA is when the issuer borrows the required credit support from a commercial bank to buy commercial paper with the highest credit quality. Since CCA is a deposit of actual money, it assures credit enhancement.

3. How to Use Credit Enhancement to Improve Your Credit Score.

Here are some simple ways to improve your credit scores:

  1. Keep track of your bills and payments
  2. Aiming for less credit utilization
  3. Keeping old accounts open
  4. Considering consolidating your debts
  5. Using credit monitoring programs to track your progress
  6. Improving your thin credit file

A thin credit file means that you do not have the significant credit history to give rise to a credit score. The broad assumption is that 75% of renters have a credit score lower than 700. Fortunately, there are ways to improve your credit score.

One of the ways to improve credit score is through Level Credit. This program charges only $6.99 per unit monthly, or a $50 one time payment to boost credit score. An added bonus is that they find your rent and utility payments and report them automatically. There is no participation from the landlord and your financial information and identity data will be completely protected.

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