In financial terms, credit enhancement is the use of a risk reduction technique to protect an investor against losses in the underlying security or debt instrument. In banking terms, credit enhancement is any technique used to improve the credit rating of an asset backed security or bond to improve marketability. These methods are often employed in both public and private project financing, and as an integral part of structured finance.
There are a number of legitimate methods which can enhance the financial stability of a debt instrument. One method is over-collateralization. Collateral is property which is pledged as security for a debt. A common example is a mortgage. If a person defaults on the loan, the mortgage holder has the right to seize the property as repayment for the loan through the foreclosure process.
If a business wishes to issue bonds or some other form of debt instrument, it can pledge assets owned as collateral for the debt. Usually, the assets pledged would be equal to the amount to be borrowed. If the company wishes to improve the credit rating of its bonds or notes, it can pledge assets with a higher value than the amount of the obligation. For example, if a business wants to issue bonds for $250,000 US Dollars (USD) and it pledges assets valued at $275,000 USD, it is using the credit enhancement technique of over-collateralization. The risk to the investor is greatly reduced, since there is more than sufficient property pledged to pay off the debt in case of a default.
Another credit enhancement technique is the use of special insurance policies or bank-issued letters of credit. These policies or letters guarantee full repayment of the debt instrument in case of a default by the issuer. Insurance policies are commonly used for projects funded by municipal bonds. The cost of procuring the insurance or letter of credit results in a somewhat reduced return on the bonds, yet they are much more marketable because of the lower risk carried by the investor.
Credit enhancement is an integral part of securitization, a form of structured finance which turns a non-liquid asset into a more liquid security. The most common of these are mortgage-backed securities (MBS) or asset-based securities (ABS). These pool together a number of financial assets such as mortgages, bonds, debt instruments, credit linked notes, or receivables from rental properties or credit card obligations. Bonds are issued to investors on the pool of assets, and the income from those assets pays the bonds.
The credit rating of an MBS or ABS is enhanced by issuing subordinated bonds. Subordination is a tiered classification method defining which debts will be paid first, and which will be paid last. Those bonds which will be paid first are called senior bonds, and have the higher credit rating because they have less risk if the income flow decreases. Junior bonds, which are the last to be paid, are subordinated to the senior bonds. They will have a lower credit rating because they carry a greater risk.
The use of structured finance is not allowed in many countries which are civil law-based and do not have trust laws. This is true in many Latin American countries. Some of the businesses in those countries, however, do use this method to increase capital for expansion and project development. In those areas, the process must be handled offshore.
There are a number of companies that also offer credit enhancement to individual consumers. While some of the techniques used by these companies are legitimate, a consumer should be very careful. Some companies “improve” the credit rating by simply adding the person’s name to a credit card account owned by an unrelated party with excellent credit. If this is being done simply to help someone qualify for a loan that he would not qualify for on his own, the practice could be considered fraudulent under some banking laws.