Introduction to Securitization

SIZING OF CREDIT ENHANCEMENTS

The size of the credit enhancement is one of the most critical factors in driving the economics of the transaction. The size of credit enhancement depends on the target rating sought for the bond classes in the proposed structure. In this section, we review how the “sizing” of the credit enhancement is determined by the rating agencies.

In quantifying the credit enhancement, the rating agencies analyze the sources available to absorb losses and keep the rated bond classes protected against losses. The losses for the asset pool are first quantified based on assumptions that the rating agencies have validated based on their historical experience with a similar statistical static pool. Then the rating agencies stress test the assumptions over a particular range of probable scenarios based on the ratings sought for the bond classes.

For every rated bond class, there will be some probability of default over time. The highest credit rating means highest safety in terms of risk of default, not absolute safety against default. Rating agencies have ample empirical evidence regarding the performance of their ratings on corporate bonds. It has only been in the past few years or so where enough empirical evidence on the performance of their ratings on asset-backed securities has become available.

Rating agencies publish two types of tables. One is the probability of default over time by rating category and is sometimes referred to as a mortality table. The ...