Asset-backed securities (ABS) are structured financial instruments that are backed by pools of underlying assets such as mortgages, auto loans, or credit card receivables. Credit risk is a core risk that securitization structures seek to mitigate. To enhance the credit quality and reduce the risks associated with ABS, various credit enhancements are often implemented in the structure. Here are some common types of used in ABS:

Internal Credit Enhancements

Overcollateralization (OC) involves structuring the ABS transaction so that the value of the underlying assets exceeds the value of the issued securities. By providing additional collateral beyond the value of the securities, overcollateralization offers a cushion against potential losses. If the underlying assets experience defaults or delinquencies, the excess collateral can absorb the losses and provide protection to the investors. For example, if the liability of the structure is $100 million and the collateral's value is $105 million, then the first $5 million loss will not result in a loss to any of the tranches.

ABS transactions often employ a senior/subordinated structure where different tranches of securities are issued with varying levels of priority in receiving cash flows. The senior tranches have the highest priority and are paid first from the cash flows generated by the underlying assets. The subordinated tranches, which have lower priority, absorb losses before the senior tranches. This structure provides credit enhancement to the senior tranches as they are less exposed to potential losses. This is also called credit tranching.

Excess spread refers to the difference between the interest income generated by the underlying assets and the interest payments made to ABS investors. The excess spread acts as a cushion against losses and provides additional cash flow to cover any potential shortfalls in the future.

A cash reserve account is established to hold a portion of the proceeds from the ABS issuance. The funds in the reserve account can be used to make payments to investors in case of shortfalls resulting from defaults or delinquencies in the underlying assets. The cash reserve account acts as a form of credit enhancement by providing a source of liquidity and protecting investors from losses.

External Credit Enhancements

Credit enhancements can be in the form of third-party guarantees, such as letters of credit, bank guarantees, surety bonds, provided by creditworthy entities. These guarantees serve to enhance the credit quality of the ABS by providing an additional layer of protection against default or credit risk.

ABS can be structured with insurance policies, such as mortgage insurance or bond insurance, which provide protection against default or credit losses. The insurance coverage reduces the credit risk associated with the underlying assets and enhances the credit quality of the ABS.

These credit enhancements aim to reduce the risk of default and provide investors with a higher level of credit protection. The specific types and combinations of credit enhancements employed in an ABS transaction depend on the characteristics of the underlying assets, investor preferences, and market conditions.