Updated July 17, 2023
What is Credit Enhancement?
Credit enhancement is the process of enhancing the credit worthiness of the products or transactions, which credit rating agencies use when the securitization process is levied in the company.
It is essential for securitization. It also improves the liquidity of the lenders. If any organization or company follows the credit enhancement process, then the company’s capacity to take borrowings increases and the interest rate decreases.
Basics of Credit Enhancement
The company or the organization follows the credit enhancement process to improve its creditworthiness. The organizations plan this strategy to achieve a lower interest rate and thus enhance their credit-taking capacity. Credit rating is also one of the essential tools in the market, which is also a deciding factor for the company’s growth. Many factors associated with the company make this process easy to implement. The management has to decide on the credit enhancement considering all the possible actions in favor of the administration. It also helps to lower the risk associated with the securities for investment purposes.
How Does Credit Enhancement Work?
The company’s management decides on credit enhancement by making a few changes in their day-to-day work. Firstly, they have to make sure that the payments to the parties are on time so there are no due payments. Secondly, the company can also diversify its business to achieve credit enhancement. The company’s creditworthiness can improve by taking care of these things. Thus if the credit enhancement is done, the credit rating will improve, and the cost of borrowing will reduce significantly.
Example of Credit Enhancement
A company plans to go for credit enhancement by appointing an insurance company. The insurance company will make sure that the investors are secured. The company’s management decides and creates an agreement with the insurance company that the bonds or securities issues will secure. In any financial distress, the insurance company will be liable to pay the investors the principal and interest. The company must pay a premium to the insurance company on time.
After implementing this process, the investors are not concerned about the company’s credit ratings. Rather, they are now worried about the insurance company’s credit rating. Thus, this helps the company clear its dues on time and focus on mainstream business because they are now free from the investors’ concerns.
Types of Credit Enhancement
- Wrapped Security: The company utilizes wrapped security 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 repay the interest and the principal.
- Surety Bonds: Surety bonds consider guaranteeing the asset-backed security in which the investors have invested their money. This type of insurance also provides against losses due to market fluctuation.
- Cash Collateral Account: A cash collateral account is a type in which the company borrows a certain amount to purchase commercial instruments. In any default-like situation, the cash can be withdrawn at any time so that the default loans can pay back. This is also a type of security given to the company in any distressed financial situation.
Use of Credit Enhancement
- It helps to improve the creditworthiness of the company. The company can take more loans from lenders to improvise their business.
- It can reduce the risk associated with the investors by including the insurance process.
- The cost of borrowing can reduce if the company follows the credit enhancement process.
Advantages
- The creditworthiness of the company can improve.
- The cost of borrowing reduces to a considerably low level so that the company can take easy loans and enhance its business.
- It also includes the process of insurance, which can help investors get insurance while they are investing.
- It also reduces the pressure on the company’s management because the investors will now be concerned about the insurance company’s credit rating. Thus the company can now focus on its operational work more effectively.
Disadvantages
- The investors will always have to refer to the insurance company’s credit rating; in the worst-case scenario, if the insurance company defaults, the entire load will be on the investors. They will not be able to contact the company for compensation.
- It 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 investors; thus, the company’s overall financial condition cannot balance.
Conclusion
Credit enhancement is an artificial process of improving the company’s creditworthiness. The investor risks are considerably lowered in this case; hence, the investors are more likely to invest in the securities. This process also helps the company to improve its credit ratings. It 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 them.
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