The increasing of the creditworthiness of securities.
Historically there were three main methods of credit enhancement in the private sector:
- Junior/Senior tranches: The entire debt is divided into so-called junior and senior tranches, with the former bearing all the first losses. Thus, the credit standing of the remaining senior tranches is raised considerably.
- Insurance: A third party, usually an insurance company, undertakes to insure the credit risk of the respective securities (called ‘wrapping’).
- Collateralisation: Securities may be backed by other financial assets, usually equity, of higher values. The difference serves as collateral for the repayment of the debt (overcollateralisation). The issuing company may also put collateral on the differential between the respective security’s original value and its current market value (margin).
The term 'credit enhancement' is now used in a much wider sense, to include additionally various forms of support provided by national governments, government-sponsored agencies and international agencies.