What is the limitation of a third-party guarantee as a form of credit enhancement?

What will be an ideal response?

As a form of external credit enhancements, the rating companies take the "weak link" approach to ratings. That is, if the rating of the third-party guarantor is downgraded, the asset-backed security's rating will be downgraded even if the collateral is performing as expected. More details including an example are given below.

All asset-backed securities are credit enhanced to provide greater protection to investors against defaults. There are two general types of credit enhancement structures: external and internal. External credit enhancements come in the form of third-party guarantees that provide for first loss protection against losses up to a specified dollar amount. Internal credit enhancements include reserve funds reserves (cash reserves and excess servicing spread), overcollateralization, and senior/subordinated structures.

In earlier credit card structures, the most popular form of credit enhancement was a bank letter of credit. However, as just mentioned above, the disadvantage of a third-party guarantee is that if the guarantor is downgraded the structure will be downgraded regardless of how the collateral is performing. With the downgrading of banks that provided letters of credit for earlier credit card deals and the subsequent downgrading of the securities, this form of credit enhancement lost its popularity.