Question

9) 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 Structure II Pool of automobile loans $301 million $305 million Senior class Subordinated class $280 million $270 milliorn $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

Ans-9) For understanding which structure would receive a higher credit rating we first need to understand the senior class and subordinate class.

Senior class and subordinate class-  senior class and subordinate class is basically a type of debt in the company. whenever the company goes for a liquidation senior debts are the first preferred debt which is paid. Therefore they are less risky their interest is also low. while the subordinate class debts are paid after every other debt because they have the lowest seniority level among all other debts, therefore they are much riskier than senior class debt. and the interest rate paid for this debt is also higher for compensating the risk given to the investor.

(a) Here the structure which has higher subordinated class will receive less credit ratings because they are riskier than any other debts. so here structure 1 has less subordinate class, therefore, it is likely that it will receive higher credit ratings than structure 2 although its automobile loan is slightly less.

(b) Credit enhancement - credit enhancement is a tool or a method through which a borrower tries to improve its debt worthiness or its debt credibility. Through credit enhancement, a borrower provides an assurance to the lender that its repayment will be fulfilled. credit enhancement can be done through various ways like insurance, letter of credit, reserve account, senior/subordinate structures, etc. In both, the structures here senior/subordinate structures are being used for credit enhancement.