Credit Risk Management Practice Exam

Which statement best describes the purpose of internal credit enhancement?

1. To reduce the total amount of issued bonds

2. To increase the yield on equity tranches

3. To protect senior tranches from losses

4. To allocate cash flows to junior bondholders

The correct answer is: To protect senior tranches from losses

The statement that internal credit enhancement aims to protect senior tranches from losses is accurate. Internal credit enhancement refers to mechanisms or structures within a financial transaction designed to improve the credit quality of certain classes of securities, typically the senior tranches in a securitization. In the context of securitization, different tranches are created with varying levels of risk and return. The senior tranches are generally less risky because they have a higher claim on cash flows generated by the underlying assets. Internal credit enhancements, such as subordination, reserve accounts, or over-collateralization, provide a buffer against potential losses, ensuring that the cash flows from the underlying assets can first be directed to these senior tranches. This structure helps to maintain their ratings, lower the cost of borrowing, and provide greater confidence to investors in those senior positions. Consequently, the utilization of internal credit enhancements serves to bolster the protection of senior tranches, ensuring that they can absorb potential losses before the junior tranches are affected. This is of utmost importance in credit risk management as it directly influences the risk assessment and pricing of various classes of securities issued in a securitization deal.