To obtain an investment credit rating and make the transaction attractive to the investors, some type of credit enhancement procedure is usually necessary. In order to cover the possibility that the loan portfolio will generate insufficient payment to fund payments of interest when due, some form of liquidity support is provided, usually by a credit facility from a third party lender. The credit enhancement part will take care of the risk involved in such receivables that will in turn protect the SPV against potential default in respect of the receivables acquired.
Since this process of securitization often involves dealing with the backing of assets, it is referred to as Asset-Backed Securitization (ABS). There is another form of securitization that deals with mortgages instead of assets called Mortgage-Backed Securitization (MBS).
In MBS, securitization is done on a pool of mortgages that are placed with the originator. Say, in case of a housing finance company which finances construction/ acquisition of dwelling units in return for mortgaging such dwelling units. The housing finance company may securitize the mortgages thereby seeking the advantages of securitization. Most other factors remain the same as in ABS.
Some forms of credit enhancement are: Overcollateralization, Cash Reserve Account, Subordination, Issuer Limited Recourse in case of high risk receivables such as NPAs, Letter of Credit, Mortgage Pool Insurance and Financial Guarantee by the banker of the originator on the receivables.
Differences between Asset-Backed Securitization and Mortgage-Backed Securitization
Though, it was stated earlier that any resource with predictable cash flows could be securitized, the investment bankers perceive that to make a resource attractive as a raw material for securitization, the following features must be present.
The asset portfolio must have a documented history showing loss and delinquency experience.
The historical loss on the portfolio must have been modest.
The assets must have originated from standardized contracts.
The asset portfolio must have been so structured that the risk is well-diversified.