Series 7 practice questionhardABS — Credit Enhancement
Which of the following is a form of internal credit enhancement used in asset-backed securities?
- AA letter of credit from a bank
- BA surety bond from an insurance company
- COvercollateralization, where the value of collateral exceeds the value of securities issued✓ Correct answer
- DA corporate guarantee from the parent company
Explanation
Why C — Overcollateralization, where the value of collateral exceeds the value of securities issued
Overcollateralization is an internal credit enhancement technique where the face value of the underlying asset pool exceeds the face value of the securities issued. This excess collateral provides a cushion to absorb losses from defaults in the underlying pool. Other internal credit enhancements include subordination (tranching) and excess spread. External credit enhancements include letters of credit, surety bonds, and insurance wraps.
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