188.8.131.52. Internal Credit Enhancement
The most common forms of internal credit enhancement are subordination, overcollateralization, and reserve accounts.
Subordination, also known as credit tranching, is the most popular internal credit enhancement technique. It relies on creating more than one bond class or tranche and ordering the claim priorities for ownership or interest in an asset between the tranches. The cash flows generated by the assets are allocated with different priority to tranches of different seniority. The ordering of the claim priorities is called a senior/subordinated structure, where the tranches of highest seniority are called senior followed by subordinated or junior tranches. The subordinated tranches function as credit protection for the more senior tranches, in the sense that the most senior tranche has the first claim on available cash flows. This type of protection is also commonly referred to as a waterfall structure because in the event of default, the proceeds from liquidating assets will first be used to repay the most senior creditors. Thus, if the issuer defaults, losses are allocated from the bottom up—that is, from the most juniorto the most senior tranche. The most senior tranche is typically unaffected unless losses exceed the amount of the subordinated tranches, which is why the most senior tranche is usually rated Aaa/AAA.
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