Question

A corporation is considering a securitization and is considering two possible credit enhancement structures backed by a pool of automobile loans. Total principal value underlying the asset-backed security is $300 million.

Principal Value for:	Structure I	Structure II
Pool of automobile loans	$301 million	$305 million
Senior class	$280 million	$270 million
Subordinated class	$20 million	$30 million

Answer the below questions.

(a) Which structure would receive a higher credit rating and why?

b) What forms of credit enhancement are being used in both structures?

Answer 1

a) The Senior class of structure 2 will receive a higher credit rating as more collateral is posted than the original amount of the loan. This rating is based on over - collateralization.

Generally, a subordinated class will receive a lower rating. If we give ratings on the basis of senior/subordinate structure , we will give higher ratings to Structure I. As it has a lower subordinate class.

So, both of these structures can get a equal rating.

b) The forms of credit enhancement being used in both the structures in Over-collateralization and senior/subordinate structures, In this method excess amount is put into the pool, which is higher than the amount being issued as a ABS.The value of the ABS is $300, and structure 1 has excess pool of amount $301, an structure 2 has excess pool of amount $305. So,structure 2 has a higher over- collateralization than structure 1. Both the structures have a senior/subordinate structure.

Senior/subordinate structure: This is when senior tranches are created with superior claims on the cash flows compared to other tranches. In other words, the subordinated tranches absorb losses first.