Credit enhancement, also known as “credit support,” is a strategy used to provide lenders with financial support during times of economic stress.  This risk– reduction strategy helps lenders cover losses from defaults, protect against deteriorating market conditions, and hedge against other adverse scenarios.  

 

Credit enhancements are regularly used across sectors and asset classes, including:  

 

• ABS (asset-backed securities); 
• MBS (mortgage-backed securities); 
• CDOs (collateralized debt obligations); and 
• CBOs (collateralized bond obligations) 

 

Types of credit enhancements include: 

         1. Loan Loss Reserves (LLRs)  

 

This method provides partial risk coverage by reserving a specific amount of money to pay for potential losses.  For instance, a 10% LLR on a $120 million loan portfolio could cover as much as $12 million of that capital provider’s losses. 

         2. Loan Guarantees 

 

Loan guarantees fully cover loan portfolio losses incurred by capital providers.  These differ from loan loss reserves because they have no repayment limit, while LLRs are capped by the reserves. 

         3. Loan Loss Insurance (LLI) 

Loan loss insurance is a private insurance product targeted to lenders.  A lender can purchase LLI on its own behalf, or a grantee can purchase LLI on the lender’s behalf.  LLI is somewhat similar to a loan loss reserve, and it will cover a portion of a lender’s total losses up to a predetermined cap. 

 

However, LLI differs from LLR in one crucial way.  Rather than setting money aside in a reserve account to cover any potential losses (like a loan loss reserve), with LLI, the lender or grantee instead pays insurance premiums to a private insurer. 

         4. Debt Service Reserves (DSRs) 

Debt service reserves (or “DSRs”) are funds lenders set aside in order to pay for late or defaulted loan payments.  For example, lenders may need to set aside a 3-6 month DSR in order to ensure their debt obligations are covered if the loan portfolio goes south. 

         5. Senior/Subordinated Capital Structure 

 

With a senior/subordinated capital structure, sponsors can place two capital types into a single loan or loan portfolio.  At the bottom of the capital stack is the subordinated capital, which may absorb any first losses on the loan at a limit that might be capped at 5, 10, or even 20%, depending on the structure of the deal.  Conversely, senior capital absorbs no losses until the subordinated capital is gone.  

 

A senior/subordinated capital structure is similar in many ways to a loan loss reserve and is particularly attractive for senior capital because of the lowered risk compared to the subordinated capital. 

 

 

Why use credit enhancements in lending? 

 

Going through the credit enhancement process helps lower the credit risk of a given debt, helping to increase general creditworthiness.  This applies whether you’re looking at the overall credit rating for a bank, or an individual borrower’s credit score.  Credit enhancement also creates a level of reasonable security for the lender, allowing the lender to focus on what matters – maximizing loan portfolio value. 

 

If you’re worried about the near-term economic outlook, you’re not alone.  Americans of every stripe – including many lenders – are concerned about the potential blowback from higher interest rates, fueled by both reduced liquidity and volume, and growing default rates in residential and commercial lending. 

 

Credit enhancements can provide some protection from market turmoil, with solutions like Axy Wrap® offering risk mitigation including protection from early and first payment defaults.  

 

Axylyum’s innovative “wrapping” method offers unparalleled seasoning protection, with lenders receiving 100% of the unpaid principal balance for any defaulted asset.  Lenders simply call in the option and have funds wired as soon as the next day, taking the default off of your balance sheet and allowing you to continue lending.  Try Axy Wrap® today! 

Legal Disclaimer:

This article does not constitute an offer to sell, or the solicitation of an offer to buy, any security interest in any jurisdiction. This material is distributed for informational purposes only and should not be construed as investment, legal, tax, regulatory, financial, or other advice. No assurance can be given that any investment objective will be achieved, or that an investor will avoid losses or obtain a return on an investment. While the information contained in this article is believed to be reliable, its accuracy is not guaranteed. Individuals should consult with their own professional advisors with respect to the legal, tax, regulatory, financial, and accounting consequences of any potential investment.