V. Credit enhancement.

• Author: Jobst, Andreas A.
• Position: Collateralised Loan Obligations (CLOs

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...