V. Credit enhancement.

The willingness of the sponsor to retain an equity claim on the collateral pool as credit enhancement is largely driven by the structure of the CLO transaction. The lower the asset quality of the selected reference portfolio of loans in a true sale transaction, the higher the price discount (44) sponsors will need to grant the issuing party (i.e. the SPV) in achieving a desired portfolio rating. Hence, high levels of first loss provision indicate a large difference between the sponsor's rating assessment of the underlying loans and the desired rating for the structured claim thereon. This does not, however, give rise to a definite valuation of the reference (collateral) portfolio, because a sponsor has significant leeway in deciding on the desired rating to be achieved by means of securitising a given collateral of loans. Thus, any level of first loss protection of a CLO transaction is merely the result of the endogenous willingness of the bank to cover expected losses of the reference portfolio. At the same time, this decision is bounded by the conditions imposed by rating agencies in their credit risk assessment of the reference portfolio and the structure of the transaction, for the degree of minimum credit enhancement is exactly determined by securitisation guidelines of external rating agencies.

From regulatory point of view, the credit enhancement is termed a direct credit substitute (CDS), which meets the classic definition of a credit derivative, as its value derives from the price movement of the underlying asset, i.e. the reference portfolio of the securitisation. Such credit derivative instruments frequently represent concentrated risk for providers of credit enhancements. In a bank-sponsored conduit issue, such as conventional CLOs and synthetic CLOs with SPV, the most junior tranche retained by the sponsor commonly represents the first loss credit protection for the total notional balance of the transaction. The amount of first loss provision is chosen such that it absorbs default losses up to a certain percentage. The sponsor effectively incurs all estimated credit default risk of the underlying reference portfolio of loans. As this level of credit enhancement has an extremely remote probability of being fully depleted, the concentration of all credit risk of the loan pool onto a smaller asset base in the form of such credit supports yields a high investment-grade rating of senior claims on the reference portfolio. Consequently, the degree of this implicit leverage on credit risk invalidates hitherto regulatory treatment. Given the concentration of the entire portfolio credit risk in the credit enhancement a commensurate capital charge would represent a multiple of what has previously been deemed the appropriate regulatory requirement for the total volume of securitised loans.

From the issuer's perspective, calibrating the level of credit enhancement is predicated on a detailed credit assessment of the reference portfolio of loans. Rating agencies ascertain the credit enhancement level for a reference portfolio based on the analysis of credit quality, expected loss and pool diversity required for senior and mezzanine classes to achieve the desired rating on the CLO structure of issued debt securities. The credit enhancement calculation model developed by Standard and Poor's shall serve as guideline in introducing the fundamental parameters entering calculation of the level of first loss position (generally retained by the sponsor of the securitisation transaction). The following criteria apply: (i) average maturity of the reference portfolio, (ii) historical performance, (iii) debtor concentration, (iv) record of payment delinquencies, (v) default rate of portfolio, and (vi) dilution of asset claims/receivables.

These parameters are subjected to stress scenarios, so that the level of so-called dilution reserve and default reserve can be determined. The sum of both represents the required credit enhancement for the respective transaction. In the context of CLOs the credit enhancement signifies the resilience of the reference portfolio to sustain an amount of scheduled losses (determined by the desired structured rating) without compromising the continued servicing of issued debt securities. This residual credit risk underpins a lower level of default tolerance of structured claims on the reference portfolio. Consequently, the amount of credit enhancement reconciles the discrepancy between the credit quality of the reference portfolio and the rating benchmark desired by the sponsor/issuer of the CLO transaction for purposes of lowering the default tolerance. The larger this difference the more funds have to be made available for sufficient credit risk cover by means of credit enhancement.

In their exposition of the function of credit enhancement, Herrmann and Tierney (1999) refer to base case 10-year cumulative default rates and base case recover), rates in an exemplary derivation of the credit enhancement level required by two of the three major rating agencies Moody's, Fitch IBC and Standard & Poor's. Given a diversified pool of B-rated (non-investment grade) collateral, Moody's would estimate a default rate of 31.8% and a loss rate of 22.3% of the entire portfolio respectively (assuming a conservative recovery rate of 30% of assets). In order to achieve a desired structured rating of Aa2 for tiffs portfolio in the wake of a CLO transaction, default tolerance has to be lower. The higher rating assumes a lower default frequency such that the tolerance of a higher default rate increases at the same expected loss expected loss = default frequency/probability of default x loss sererity as before.

In the case of a desired investment-grade rating of Aa2 the rated class must now survive higher default and loss rates (39% and 55.7% respectively) of the reference portfolio, which implies a subordination of 39% of the reference portfolio value in equity tranches as credit enhancement. Fitch IBC would require a slightly lower default rate of 52.3% due for an AA-rated class based on the assumption of a based default rate of 29.9% for a B-rated collateral. As the desired rating rises, the marginal reduction of loss expectation is compensated by a commensurate degree of credit enhancement as the migration from a non-investment-grade rating to a AA-rating equates to the significant reduction in the variance of default probability. Thus, credit enhancement truly serves as a safety mechanism to protect investors in senior and mezzanine tranches of CLOs from default loss in excess of estimated losses.

Andreas A. Jobst

London School of Economics and Political Science (LSE) and J.W. Goethe Universitat Frankfurt am Main