Are Credit Enhancements Risk-Sensitive? A New Technique for Evaluating Structured Finance Ratings Performance

Abstract

This article looks at the relationship between credit enhancements supporting structured finance transactions and the realized credit performance of the underlying pool of collateral assets. Based on samples of structured finance transactions across U.S. commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), credit card asset-backed securities (ABS), and auto loan ABS, the study finds a positive correlation between the size of enhancement levels (at a given rating category) and statistical measures of realized collateral performance, encompassing a broad range of vintages. More specifically, higher enhancement levels are generally associated with weaker collateral performance; however, the correlation and statistical robustness of this relationship vary across asset classes and rating levels. As a measure of structured finance ratings performance, this technique has the advantage of explicitly analyzing both enhancements and collateral and helps to provide insight into the sensitivity of enhancements to differences in risk profiles of pools of collateral assets.