Why is credit enhancement required in a securitization?

What will be an ideal response?

Credit enhancement is required for all asset-backed securities to provide greater protection to investors against losses due to defaults by borrowers. More details on credit enhancement are given below.

In Chapter 11, we briefly reviewed the different forms of credit enhancement for nonagency MBS. They include external credit enhancement and internal credit enhancement. The credit enhancement forms are used both individually and in combination, depending on the loan types that are backing the securities.

External credit enhancement involves a guarantee from a third party. The risk faced by an investor is the potential for the third party to be downgraded, and, as a result, the bond classes guaranteed by the third party may be downgraded. The most common form of external credit enhancement is bond insurance and is referred to as a surety bond or a wrap.

Internal credit enhancements come in more complicated forms than external credit enhancements and may alter the cash flow characteristics of the loans even in the absence of default. Credit enhancement levels (i.e., the amount of subordination for each form of enhancement utilized within a deal) are determined by the rating agencies from which the issuer seeks a rating for the bond classes. This is referred to as "sizing" the transaction and is based on the rating agencies' expectations for the performance of the loans collateralizing the deal in question.
Most securitization transactions that employ internal credit enhancements follow a predetermined schedule that prioritizes the manner in which principal and interest generated by the underlying collateral must be used. The most common forms of internal credit enhancement are senior/subordinate structures, overcollateralization, and reserve funds.