How can excess spread be a form of credit enhancement?
What will be an ideal response?
Credit enhancement is the process of reducing credit risk by requiring collateral, insurance, or other agreements to provide the lender with reassurance that it will be compensated if the borrower defaulted. Excess spread, also referred to as excess interest, is basically the interest from the collateral that is not being used to satisfy the liabilities (i.e., the interest payments to the bond classes in the structure) and the fees (such as mortgage servicing and administrative fees). The excess spread can be used to realize any losses. If the excess spread is retained in the structure rather than paid out, it can be accumulated in a reserve account and used to pay not only current losses experienced by the collateral but also future losses. Hence, excess spread is
a form of credit enhancement.Because the loan rate on subprime loans is greater than the loan rate on prime loans and because the expected losses are greater for subprime loans, excess spread is an important source of credit enhancement for subprime MBS.
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