Credit Risk Management Practice Exam

Which type of credit enhancement involves providing more collateral than is necessary?

1. Pool insurance

2. Subordinating note classes

3. Overcollateralization

4. Margin step-up

The correct answer is: Overcollateralization

Overcollateralization is a credit enhancement technique that involves providing more collateral than is necessary to secure a debt obligation. This approach serves to reduce the risk of loss for investors or lenders because the added collateral provides a buffer in the event of borrower default or depreciation of the underlying asset's value. In practice, overcollateralization ensures that there are sufficient assets to cover the principal and interest payments, thereby enhancing the credit quality of the security. By requiring more collateral than the amount of the loan or investment, lenders can secure additional assurance that their interests will be protected even if the borrower faces financial difficulties. For example, if a loan is secured with collateral valued at $100,000 but the loan amount is only $80,000, the additional $20,000 acts as a safety net. This mechanism is particularly common in asset-backed securities and structured finance transactions, where cash flow can be unpredictable. The presence of excess collateral not only helps to mitigate credit risk but can also make the securities more attractive to investors by providing a greater cushion against losses.