Fundamental Elements in Credit Ratings
A credit rating is an opinion expressed by a credit rating agency on the credit risk of an obligation. The credit risk can be generically interpreted as the likelihood of default, in which case the investor will not be paid in accordance to the terms of the obligation.1 For an asset securitization transaction, the credit risk describes the likelihood that investors will not receive timely interest and ultimate principal payments before the legal final maturity of the transaction. In order to protect investors against such risk, asset securitization credit ratings design necessary credit-enhancement levels under various scenarios so that investors will receive timely payments. The credit-enhancement specifics for the various credit classes of all non-agency-guaranteed securitization transactions discussed in this book are derived from a rigorous credit rating process that consists of five fundamental elements. They are:
- evaluating credit quality of the underlying assets;
- reviewing payment structure and cash-flow mechanics;
- analyzing legal and regulatory risks;
- assessing operational and administrative risks;
- examining third-party dependencies.
Evaluating Credit Quality of the Underlying Assets
Since the credit of an asset securitization transaction is derived from that of the pool of underlying assets, evaluating the credit quality of the assets is a critical element of the credit rating process. First and foremost, it needs to ...