Credit enhancement amount

To achieve a true sale, an originator must limit, if not forego, its right to the residual value of the receivables sold to the SPV. This residual value can often be significant since the SPV must obtain a level of receivables well in excess of the amount necessary to pay the securities issued by the SPV. Such "overcollateralization" is needed to assure investors and providers of liquidity and credit enhancement that they will not suffer losses from delayed collection or defaults. Conflict may develop over the amount of overcollateralization necessary for the SPV originators want the level of overcollateralization to be low, while investors and credit enhancers want it to be high. Because the amount of receivables... 

In the author s experience, the cost of credit enhancement ranges between 0.40% and 0.75% of the amount of credit extended, and the cost of liquidity ranges between 0.15% and 0.35% of the amount of the commitment made available. These amounts fluctuate depending on the particular transaction and the supply of suitable parties willing to provide such enhancement or liquidity. 

The amount of credit enhancement for a transaction is determined by the rating agencies and varies by issuer depending primarily on the performance of the underlying collateral. Exhibit 13.9 shows total enhancement levels for three recent transactions completed by different issuers. 

Strictly speaking, the FIAT 1 transaction does not generate excess spread. This explains the high level of credit enhancement from the unrated class M notes (usually, unrated tranches are either privately sold or kept as an equity tranche by the originator). On the closing date, an amount of notes was issued which was equal to the net present value of all future cash payments due from the collateral (as opposed to the principal balance of the collateral). The discount rate used was the fixed rate payable to the swap counterparty (swap rate plus coupon on the class A notes and all fees associated with the transaction). Structured this way, the receivables always yield the discount rate, leaving no excess spread in the transaction. However, losses on the FIAT 1 portfolio can be covered to a certain degree from interest collections because the structure provides for delinquent principal and defaults to be covered before interest is paid on the class M notes. 

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