Credit Enhancements and How They Work?

Scared about losing your investment? Credit enhancement is a risk reduction approach to safeguard an investor against losses in the underlying asset or debt instrument. Credit enhancement is an approach used to raise the credit quality or rating of an asset-backed instrument or bond in order to increase marketability. Let’s deep dive into knowing what credit enhancements are and how they can protect your funds.

What is Credit Enhancement?

Credit enhancement is a strategy for strengthening the credit risk profile in order to receive better conditions for loan repayment. It is used to lower the risks to investors of certain structured financial instruments. Many market crashes have afflicted the?financial sector during the past 100 years. For example,?the 1929 Great Depression or the 2008 financial crisis. In such scenarios, credit enhancement becomes more crucial than just improving creditworthiness and leads to systemic benefits.

Issuers primarily use credit enhancement strategies to reduce the amount of interest that must be paid for a specific security because high creditworthiness equates to a good credit rating, which ultimately means that an investor’s investment will reap the benefits assured when the security is issued in the market. When creditworthiness is poor, the credit rating suffers, making it undesirable for investors to invest since they risk losing their money.

Credit enhancement can help to lower the interest rate that a borrower has to pay on their debt, it can make security or investment more attractive to investors by improving its credit quality and reducing its risk. It protects lenders and investors from losses in the event of a default, which can help to maintain market stability and bolster investor confidence and access new sources of financing that may not be available otherwise.

If you’re?considering lending, understanding credit enhancements and how to effectively utilize them can significantly boost your potential rewards while minimizing your risks.

Internal and External Credit Enhancements

Credit enhancements can be internal or external. Internal enhancements are provided by the issuer or borrower themselves or are part of the structuring of the credit. External enhancements are provided by third parties.

Internal Credit Enhancements

Internal credit enhancements are measures taken by asset-backed securities issuers to reduce the risk of default and improve the creditworthiness of the securities. These measures can include cash reserve accounts, excess servicing spread accounts, over-collateralization, and senior/subordinate structures.

Cash Reserve Accounts:?Cash reserve accounts are funds set aside by the issuer from the proceeds generated throughout the fundraising process. These funds can be accessed if needed to cover any losses or defaults on the securities. This provides a safety net for investors and increases the creditworthiness of the securities.

Excess Servicing Spread Accounts:?Excess servicing spread accounts involve adding a basis point cushion over the servicing cost between the assets’ gross weighted average coupon and the weighted average coupon owed to asset-backed securities investors. This surplus spread is put into an account and is available for withdrawal as needed. This measure ensures that there is enough cash flow to service the securities and reduces the risk of default.

Overcollateralization:?Overcollateralization is another credit enhancement measure where the value of the assets backing the asset-backed security exceeds the outstanding principal payable to bondholders. In the case of a default, the extra assets can be utilized to compensate asset-backed security holders. This provides a safety buffer for investors and reduces the risk of default.

Senior/Subordinate Structure:?The senior/subordinate structure involves issuing more than one tranche for the asset pool, with the subordinate tranches bearing losses before the senior tranches in case of a default. This provides a seniority hierarchy for investors, with the more senior tranches being considered less risky and therefore having a higher credit rating.

Example of Internal Credit Enhancements

Say a lender purchases a commercial mortgage-backed security deal, they have two layers of credit enhancement. The first is at the loan level, where the loan is overcollateralized. Further, depending on the tranche, lenders might have a second degree of protection that comes from their hierarchy in the structuring of the credit.

For example, if a borrower has a $100 million loan on a $150 million property, the borrower has $50 million in equity. For that specific property, the loan to value (LTV) is 67%. Hence, ideally, the first loss should not befall any lender until that equity has been more than wiped out, or has dropped in value by more than 33%. This is the protection offered by over-collateralization.

Therefore, if the $150 million value drops to $75 million, putting the lenders $25 million underwater, you should take a step back and say, “Let’s look at the second level of protection that we have.”

The second degree of protection a lender gets if they hold the top tranche. In this case, the $25 million of loss will be first borne by the first loss lender, and if that is wiped out, then it will be borne by the second loss bondholder, and so on up the cascade to the top tier tranche you are on. This is the protection offered by having multiple senior and junior tranches in a structured loan product.

In a credit enhancement structure, losses can be allocated differently among different holders depending on the terms of the agreement.

External Credit Enhancements

External credit enhancements are often used in third-party procedures to supplement internal credit enhancements. Bond insurance, for example, might be obtained from an insurance firm for the asset pool. If the credit quality of the third-party insurer or guarantor deteriorates, so will the credit quality of the asset-backed security.

Bank Guarantees:?A syndicate of banks is the primary funder in many infrastructure projects. In exchange for a charge, infrastructure corporations would sometimes ask one of these banks to guarantee their cash flows. This significantly improves the position of the other creditors. This is because they no longer have to depend on the underlying infrastructure company’s cash flow generation potential. Alternatively, they may depend on a stronger institution, such as a bank, to provide cash flow. Banks, on the other hand, will only agree to issue a guarantee if they have some influence over the process. Before issuing a bank guarantee, most banks need the authorities to regularly monitor the project as well as the company’s records.

Supplementary Income:?In certain circumstances, the cash flow from another project is packaged with the cash flow from the underlying project, which lessens the inherent riskiness of relying on the cash flow from one project. This is analogous to the idea of excessive collateralization in bond issuance. It lowers the risk for potential investors and, as a consequence, lowers the interest rate that must be paid in order to access the funds.

Personal Guarantees:?Personal guarantees are used to mitigate credit risk in financial transactions. A personal guarantee is a commitment by an individual, typically the owner of a business or a principal investor, to assume responsibility for the repayment of a loan or other financial obligation in the event that the borrower defaults.

Personal guarantees are used to support the creditworthiness of a borrower or issuer of debt securities. By providing a personal guarantee, the guarantor agrees to use their personal assets, income, and creditworthiness to support the repayment of the loan or debt securities in the event of default.

Personal guarantees can be an effective way to enhance the creditworthiness of a borrower or issuer, as they provide an additional layer of protection for lenders or investors.

Credit Insurance:?Credit insurance is a type of insurance policy that protects lenders and investors against the risk of non-payment by borrowers or counterparties. The insurance policy typically covers a specified percentage of the value of the loan or security and pays out in the event of default.

By using credit insurance, lenders and investors can reduce their exposure to credit risk, and potentially improve the credit rating of the debt security or loan. This can make the debt security or loan more attractive to investors and can help to lower the cost of borrowing for the borrower.

Credit insurance also provides other benefits, such as increased liquidity and access to funding, by reducing the amount of capital that lenders and investors need to hold in reserve to cover potential losses.

Polytrade’s?lender pool to finance RWAs?are backed by insurance. We use credit insurance from Coface, Mercury, and AIG to protect against the risk of default or non-payment. By choosing reputable insurance providers like Coface, AIG, and Mercury, we have taken steps to mitigate risks and insure every invoice.

Web3, Blockchain, and Credit Enhancements

Has technology helped credit enhancement? Yes, blockchain has the ability to facilitate secure, decentralized, and tamper-proof transactions that helps enhance the creditworthiness of borrowers and financial instruments. For example, by leveraging smart contracts on a blockchain, lenders and borrowers can agree on specific terms and conditions, including repayment schedules, collateral requirements, and interest rates. The use of smart contracts can eliminate the need for intermediaries, such as banks or credit rating agencies, to oversee the credit enhancement process.

Blockchain provides a secure and transparent record of all transactions and financial information, reducing the risk of fraud and improving credit ratings. By using blockchain-based credit reporting systems, lenders and credit agencies can have access to real-time data, improving their ability to assess creditworthiness and make lending decisions.

In the DeFi ecosystem, tranching is typically achieved through the use of smart contracts on blockchain platforms like Ethereum. A pool of assets is divided into different classes or tranches.

One example of tranching in web3 is the use of?collateralized debt positions (CDPs)?at MakerDAO. MakerDAO is a decentralized lending platform that allows users to borrow a stablecoin called DAI by depositing collateral in the form of ether (ETH) or other ERC-20 tokens. The collateral deposited by users is divided into different tranches, with each tranche corresponding to a different level of risk and reward.

The highest tranche, known as the senior tranche, has the lowest risk and earns the lowest interest rate, while the lower tranches, known as the junior tranches, have higher risk and earn higher interest rates. In the event of default or liquidation, the senior tranche is repaid first, followed by the junior tranches in order of seniority.

Another example of tranching can be taken from?Goldfinch Finance. Let’s say a borrower wants to borrow $100,000. Goldfinch assesses the borrower’s creditworthiness and assigns them a risk score. Based on the risk score, Goldfinch will divide the loan into multiple tranches, each with a different level of risk and potential return.

• Tranche A: This is the safest tranche and has the lowest potential return. Lenders who invest in Tranche A would receive their principal and interest payments before any other tranche. However, the interest rate on Tranche A would be lower than the other tranches, reflecting the lower risk.
• Tranche B: This tranche has a higher potential return than Tranche A but is also riskier. Lenders who invest in Tranche B would receive their principal and interest payments after Tranche A but before Tranche C.
• Tranche C: This is the riskiest tranche with the highest potential return. Lenders who invest in Tranche C would receive their principal and interest payments after Tranche A and Tranche B.

The way Goldfinch works is that there are “backers” who diligence the opportunity and take the junior tranche. The Goldfinch senior pool automatically allocates capital to the opportunity in a junior-to-senior ratio maintained by the Goldfinch Governance. In this way, goldfinch senior investors are always protected by the junior tranche put up by the “backers”.

Each tranche would have a different interest rate and repayment schedule based on its level of risk. Lenders on the Goldfinch platform can choose which tranches to invest in based on their risk appetite and desired returns.

Tranching allows for the creation of more complex financial instruments and structures, as well as providing a way to manage risk in a decentralized manner.

Blockchain Technology in Securitization

Securitization using blockchain technology is one of the more recent breakthroughs in the use of blockchain in finance. Despite the benefits of loan origination, underwriting, rating assignment and reviews, loan servicing, smart contracts, and secondary market trading, blockchain technology has a long way to go in securitization. The capacity to manage financial assets on a blockchain through securitization will let financial experts focus on their appetite for risk.

SAFU

The?Secure Asset Fund for Users (SAFU)?is an emergency insurance fund created by Binance in July 2018 to safeguard the funds of users. Binance contributed a proportion of trading fees when it launched the fund in order to develop it to a sizeable amount to protect users. The fund holds 10% of all trading fees to indemnify customers in case the exchange is hacked. SAFU fund wallets include BNB, BUSD, and BTC. The wallet addresses where the funds are stored are also publicly available, adding transparency to the initiative.

The purpose of the SAFU is to provide an additional layer of security and protection for users’ funds in the event of a security breach or other unexpected event. For example, if an exchange is hacked and funds are stolen, the SAFU fund can be used to reimburse users for their lost funds. The establishment of the fund was seen as a positive step towards protecting the funds of the investors.

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