Credit Enhancement

Refers to the features, facilities or rights within the transaction, intended to protect investors from losses with respect to securitised cash flows. Credit enhancement aims to mitigate Credit Risk within the transaction, credit enhancement can be in the form of External Credit Enhancement or Internal Credit Enhancement. It is also sometimes categorised as being either hard credit support (in place from the time the transaction closes) or soft credit support (may be partially in place at the time the transaction closes, but may build up over the life of the transaction).

Here are some examples of credit enhancement in securitisation:

A securitisation of mortgages might have a reserve fund of 5% of the face value of the mortgages. This means that if 5% of the mortgages default, the reserve fund will be used to pay off the debt.
A securitisation of credit cards might be overcollateralised by 10%. This means that the value of the underlying credit cards is 10% greater than the amount of debt that is issued.
A securitisation of loans might have a senior/subordinated structure, with the senior tranches having a 90% priority claim on the cash flows from the underlying assets. This means that if there are any losses, the subordinated tranches will bear the losses first.