Internal credit enhancement (ICE) refers to mechanisms that are used to reduce the risk of default for a securitisation. ICE can be used to increase the credit rating of the securitisation, which can make it more attractive to investors.
There are a number of different types of ICE, including:
- Reserve funds: A reserve fund is a pool of money that is set aside to cover losses in the event of defaults.
- Overcollateralisation: Overcollateralisation occurs when the value of the underlying assets exceeds the amount of debt that is issued.
- Senior/subordinated tranches: In a senior/subordinated structure, the senior tranches have first claim on the cash flow from the underlying assets. The subordinated tranches only receive payments if the senior tranches have been paid in full.
- Credit derivatives: Credit derivatives are financial instruments that can be used to transfer credit risk. For example, a securitisation issuer could enter into a credit default swap (CDS) with a third party. In the event of a default, the third party would be obligated to pay the securitisation issuer the amount of the loss.
ICE can be used in a variety of securitisation transactions, including mortgage-backed securities (MBS), asset-backed securities (ABS), and collateralized debt obligations (CDOs).
Here are some of the applications of ICE in securitisation:
- To increase the credit rating of the securitisation: A higher credit rating makes the securitisation more attractive to investors and can lower the cost of borrowing for the securitisation issuer.
- To reduce the risk of default: ICE can help to reduce the risk of default by providing a cushion against losses in the event of defaults.
- To make securitisation transactions more attractive to investors: Investors are typically more willing to invest in securitisation transactions that have ICE.
- To reduce the cost of borrowing for the securitisation issuer: The securitisation issuer may be able to borrow money at a lower interest rate if the securitisation has ICE.
ICE can be a useful tool for both investors and originators. For investors, it can help to reduce the risk of default and to make securitisation transactions more attractive. For originators, it can help to reduce the cost of borrowing and to increase the liquidity of the securitisation market.