Definition of Credit Enhancement
Credit enhancement is the process of enhancing the credit worthiness of the products or transaction which is further used for credit rating agencies whenever the securitization process is levied in the company. Credit Enhancement is important for securitization. Credit enhancement also improves the liquidity of the lenders. If any organization or company follows the process of credit enhancement then the company’s capacity to take borrowings increases and simultaneously the interest rate gets reduced.
The credit enhancement process is followed by the company or the organization in order to improve the credit worthiness. The organizations plan this strategy to achieve a lower interest rate and thus improve their credit taking capacity. The credit rating is also one of the important tools in the market which is also a deciding factor for the company’s growth. There are many factors associated with the company which makes this process of credit enhancement easy to get implemented. The management has to take a decision for the credit enhancement considering all the possible actions which is favour of the management. Credit enhancement also helps to lower the risk associated with the securities for investment purposes.
How Does It Work?
The company’s management makes a decision of credit enhancement by making few changes in their day to day work. Firstly, they have to make sure that the payments to the parties are on time so that there are no due payments. Secondly, the company can also diversify its business in order to achieve credit enhancement. By taking care of these things the credit worthiness of the company can be improved and thus if the credit enhancement is done then the credit rating will be improved and the cost of borrowing will reduce significantly.
Example of Credit Enhancement
A company is planning to go for credit enhancement by appointing an insurance company. The insurance company will make sure that the investors are secured. The management of the company takes the decision and makes an agreement with the insurance company that the bonds or the securities that are being issued will be secured. In case of any financial distress, the insurance company will be liable to pay the principal and the interest to the investors. The company is required to pay a premium to the insurance company on time.
Now after implementing this process the investors are not much concerned about the credit ratings of the company rather they are now concerned about the insurance company’s credit rating and thus, this helps the company to clear their dues on time and can focus on the mainstream of business because they are now free from the investors’ concern. Hence the process of credit enhancement can help the investors and the company as well.
Types of Credit Enhancement
- Wrapped Security: Wrapped security is a type of credit enhancement that is used by the company by appointing an insurance company. The securities are insured by the insurance company where the risk associated with the credit rating lies with the insurance company. In case of any price fluctuation the insurance company will bear the risk and will repay the interest as well as principal.
- Surety Bonds: Surety bonds are considered to guarantee the asset-backed security in which the investors have invested their money. This is also a type of insurance that is given against the losses which may occur due to the market fluctuation.
- Cash Collateral Account: A cash collateral account is also a type of credit enhancement in this process the company borrows a certain amount to purchase the commercial instruments. In case of any default-like situation, the cash can be withdrawn at any time so that the defaulted loans can be paid back. This is also a type of security that is given to the company in case of any distressed financial situation.
Use of Credit Enhancement
- The credit enhancement helps to improve the creditworthiness of the company. The company can take more loans from the lenders to improvise their business.
- Credit enhancement can reduce the risk associated with the investors because credit enhancement also includes the process of insurance.
- The cost of borrowing can be reduced if the company follows the process of credit enhancement.
Some of the advantages are given below:
- The creditworthiness of the company can be improved with the help of the credit enhancement process.
- The cost of borrowing is reduced to a considerably low level so that the company can take easy loans and can enhance its business.
- The credit enhancement also includes the process of insurance which can also help the investors to get insurance while they are investing.
- The credit enhancement also reduces the pressure of the company’s management because the investors will be now concerned about the credit rating of the insurance company. Thus the company can now focus on their operational work more effectively.
Some of the disadvantages are given below:
- The investors will always have to refer to the credit rating of the insurance company and in worst case scenario if the insurance company defaulted then the entire load will be on the investors. They will not be able to contact the company for compensation.
- The credit enhancement will also affect the securities because the investors would like to invest in the securities with a high credit rating and the low credit rating securities will not get any investor and thus the overall financial condition of the company cannot be balanced.
Credit enhancement is an artificial process of improving the credit worthiness of the company. The investor risks are considerably lowered in this case and hence the investors are more likely to invest in the securities. The credit enhancement process also helps the company to improve their credit ratings. The credit enhancement also helps the company at the time of securitization. The investors should thoroughly check the credit ratings of the company or the insurance company if the securities are insured. The company should also understand the methods used for credit enhancement very well before implementing it.
This is a guide to Credit Enhancement. Here we also discuss the definition and how does credit enhancement work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –