Credit enhancement represents a variety of financial support structures that are designed to reduce or transfer risk and improve the terms on debt and debt-like instruments.
Credit enhancement typically reduces the required yield/cost of funds of debt, making it more attractive to borrowers. Credit enhancement can also improve the liquidity of a security (i.e., its tradability in a market context), which is attractive to investors. Here we evaluate credit enhancements that are internal (incorporated within the allocation of cash flows) and external to the debt structure, although the designations are not concrete and the credit enhancements described can often fall into either category.
Key considerations in determining or selecting the form and amount of credit enhancement include: the intended investor/purchaser of the security, desired rating level, the credit characteristics of the underlying assets (also known as collateral), the availability of capital for credit enhancement, and the cost of credit enhancement. Other considerations may include the limits or restrictions on the type and amount of credit enhancement available. For example, public sector credit enhancements may be subject to specific risk limitations or design requirements associated with enacting legislation or other statutes.
Internal Credit Enhancements
Internal credit enhancements are incorporated specifically into the legal structure of the securitization or other investment vehicle. They are generally designed to allocate cash flow from the underlying assets to meet the required debt service coverage levels and protect the noteholders from losses. Internal credit enhancements include:
Subordination or Credit Tranching
Senior/subordinated structures are designed to carve up cash flows from one pool of assets/collateral into multiple classes of securities within one debt offering. The securities issued by the SPV are arranged in a hierarchy of classes (or tranches), which are ranked by risk, tenor, and other qualities (FDIC 2007). Lower seniority (or subordinated) tranches are assigned a lower credit rating and serve as protective layers of the more senior, highest-rated tranche. The cash flows are prioritized to pay the most senior tranches first; the remaining available cash is then paid to next-highest tranche and continues to the most junior tranche or until available cash is exhausted. Losses flow in the opposite direction and applied to the junior tranches first and senior tranches last, based on the specifics of any deal.
Excess spread is the difference between the interest rate received on the underlying assets, also referred to as collateral, and the yield on the issued security. This mechanism is built into a wide array of securitizations, particularly for credit cards.
As an example of its use, in February 2014, Riverside County, California issued a securitization of Property Assessed Clean Energy (PACE) loans that fund a portfolio of energy efficiency local projects. The primary credit enhancement of that securitization, known as the HERO Bond,4 is an excess spread whereby the underlying collateral pays an average yield, or coupon, of nearly 8% and the rate on the securitization note pays 5% to the noteholders.5 According to Kroll Bond Rating Agency (KBRA), which rated the HERO Bond, the difference in incoming and outgoing yields represents “an excess spread available to cover losses. Any excess interest cash flows from the PACE Bond Portfolio will be available to pay principal should PACE Assessment defaults rise.” (KBRA 2014). The HERO Bond pools 5,890 PACE Assessments (i.e., home efficiency improvements) and raised $104.4 million dollars.
PACE lending, which places a tax lien on the associated property, provides a form of credit enhancement by transferring or substituting the security repayment risk to the likelihood of recovering amounts owed through property tax assessments. Because of the seniority of the tax lien (i.e., by law, taxes are repaid before other types of debt or accounts payable), the HERO Bond received an AA rating (KBRA 2014). KBRA, in assessing the portfolio, was primarily convinced of the creditworthiness (the likelihood that the principal and interest on the bonds would be repaid) based on the ability to tax the underlying real estate value rather than the technical performance of the solar systems or the regulatory environment (i.e., including net metering) that facilitates the system’s value to the customer. The rating agency indicated, “[i]n
its analysis, KBRA used historical residential real estate tax default data for the County and surrounding counties as a proxy for PACE Assessment defaults. KBRA views this as an acceptable proxy, since PACE assessments are equal in priority to other real estate taxes” (KBRA 2014).
According to KBRA, in providing the loans that comprise the HERO Bond portfolio, Riverside County implemented the following underwriting guidelines to improve the probability of repayment:
PACE lending for solar deployment is still in its infancy but is often considered a potentially valuable source of funds. PACE legislation allowing municipalities to create PACE programs has been enacted in 31 states and Washington, D.C. (NCSL 2014). Twelve states and Washington, D.C. have active PACE programs. PACE Assessment is relatively unique to energy and water efficiency and renewable energy projects, and is therefore not widely recognized as a credit enhancement for other asset classes.
The expected value of the pooled assets (representing the present value of the remaining cash flows) is larger than the debt raised under the securitization. The overcollateralization provides a reserve to make principal and interest payments if some of the payments from the underlying loans are late or default (FDIC 2007).
In the SolarCity securitizations of November 2013, April 2014, and July 2014, the securitization bond was credit enhanced through overcollateralization. The three issuances represented a present value of cash flows over the remaining life of the contracts (referred to as Aggregated Discounted Solar Asset Balance, or ADSAB) from the underlying collateral of $87.8 million, $106.2 million, and $276 million, respectively. The securitization debt, sold as notes to the noteholders, was sized far smaller, at $54.4 million, $70.2 million, and $201.5 million, respectively. The ratio of the bond size to the total asset cash flows is referred to as the advance rate. The overcollateralization equals one minus the advance rate.
Importantly, the SolarCity transactions show a steadily improving advance rate indicating the increased confidence in solar as an asset class in a very short time frame (roughly 8 months). Relatively mature industries will enjoy an advance rate of 75%-80%. In contrast, the HERO Bond, described above, received a 97% advance rate but – as mentioned – was credit enhanced primarily through security of the tax and the excess spread (i.e., the difference between incoming and outgoing interest rates) incorporated in the structure rather than overcollateralization.
A reserve account is created to reimburse the securitization manager—referred to as the issuing trust—for various types of losses and temporary shortfalls. Solar systems, for example, may require reserve accounts specifically to cover solar-related expenses (e.g., excess O&M and/or replacement of inverters) or non-solar-related expenses (e.g., prepayment, default) over the life of the security. Reserve accounts may be funded at a fixed amount or be replenishable. They may have minimum and maximum levels. If reserves dip below minimum levels because expenses are higher than incoming additions, cash is “swept” away or allocated from investor payments to reserve funds to ensure these primary services are paid for. Cash sweeps may put noteholders’ recovery of principal and interest at risk in the near term but ultimately protect the assets and cash flows over the life of the security.
A reserve account can also be external to the debt securitization funded by an entity associated with the debt issuance or an outside party. For example, in March 2014, California established a $10 million loss reserve that will backstop residential PACE programs. In the case of foreclosure or forced sale, the loan loss reserve (LLR) “will reimburse first-mortgage lenders for any losses attributable to PACE loans” (California Office of the Governor 2014). According to the California agency6 that runs the LLR Program, the goal “is to put first mortgage lenders in the same position they would be in without a PACE lien,” thereby placating a concern by the Federal Housing Financing Authority—the federal entity that oversees Fannie Mae and Freddie Mac mortgage insurance programs—that PACE programs place first mortgage holders at additional risk.
Turboing (Reducing Maturity Risk)
In a turbo structure, excess funds are paid to noteholders as principal, paying down the debt at an expedited rate. Turbo structures can shorten the expected life of the debt from “legal final maturity,” or the potential maximum duration of the debt. Shortening the security life greatly reduces risk because it reduces uncertainty. This is particularly true for solar due to limited or no long-term asset production data (particularly as module and inverter designs evolve over time) and ambiguity with respect to regulatory policy (e.g., net metering), fuel prices, technological replacements, and other potential risks perceived by rating agencies and investors (Standard & Poor’s 2014).
Additional features internal to securitized assets that may offer additional credit enhancement benefits include:
Amortization Schedule: Amortization schedule represents the rate at which securities return principal to investors. Full amortization repays the principal in full over the life of the loan. These loans are designed to closely reflect the repayment characteristics of the underlying loans from scheduled interest and principal payments. A controlled amortization repays principal in a series of defined periodic payments after a predetermined period during which only interest payments are made.
Bullet Structures: Securities designed to return principal to investors in a single payment. Bullet structures can be further delineated by whether the bullet will be paid on the expected maturity date (“hard” bullet) or not guaranteed to be paid by that date (“soft” bullet).
Floating Rate Structures: Securities that have had a floating, rather than a fixed, interest rate. The interest rate is or indexed and adjusted periodically. Common indices include the London Inter-Bank Offered Rate (LIBOR) and U.S. Treasury bills, plus a fixed margin. This technique can help avoid an interest rate mismatch between borrowers and investors.
External Credit Enhancement Strategies
External credit enhancements are those that are procured from or provided by a third party and used to protect investors or noteholders ability to recover their expected principal and interest. The addition of external credit enhancement improves the risk profile of the security to attract investors while at the same time lowering the required yield/cost of capital. External credit enhancements include:
Surety bonds are insurance policies that reimburse the security for losses related to default or unexpected expenses. A surety bond (also called a performance bond) guarantees the contract will be completed according to its terms and conditions. These bonds are different from insurance in that they are constituted by a three-party contract, whereas insurance contracts include only two parties. Insurers generally provide guarantees only to securities of investment-grade quality (BBB/Baa). An asset-backed security (ABS) combined with a surety bond can improve the securities ratings equal to that of the surety bond’s issuer. Surety bonds only make economic sense to the effect the reduction in interest costs on the debt is greater than the cost of the surety bond insurance, i.e., the net effect on the over-all cost of funds is positive.
Security Wraps/Third Party or Parental Guarantees
These products represent forms of external insurance. For example, a third party or the parent company of the ABS issuer can provide a promise to reimburse the trust for losses up to a specified amount. Ex-Im, the United States government’s official export credit agency, offers loan guarantees and export credit insurance. The bank’s 100% loan guarantees7 are available to qualified international buyers in the public and private sector for up to ten years, and will finance up to 30% of local costs. Ex-Im’s access to low-interest debt through the U.S. Treasury and ability to offer 100% loan guarantees allows the bank to achieve narrow interest rate spreads. In 2013, Ex-Im approved a $780,000 loan guarantee to finance U.S. solar module exports, supplied by Suniva Inc., to a 500 kW rooftop PV installation at Grupo Metal Intra’s main production plant in Queretaro, Mexico.
Letter of Credit (LOC)/Cash Collateral Account (CCA)
A letter of credit is an irrevocable commitment in which a commercial bank or other financial institution is paid a fee to stand by with cash to reimburse the trust for any losses actually incurred, up to the required credit enhancement amount. An LOC is usually an alternative to subordinated notes or, if the quality of assets is low, coupled with subordinated notes. Funds from the LOC may be drawn upon by the trust if the losses cannot be covered by excess interest spread or reserve. In a cash collateral account (CCA), funds from a commercial bank are deposited in an account with the highest available credit quality (e.g., short-term commercial paper) and available for pre-specified expenses to ensure the creditworthiness of the overall security.
Country-Specific Reserves/Currency Protection Mechanisms
Foreign projects, particularly in developing countries, carry additional risks that often must be credit enhanced to garner a high quality credit rating and/or be sellable in the capital markets. Currency risk is of particular concern and can cause a significant increase in the cost of debt in developing countries.