Secured Debt Credit Analysis
Securitized or secured debt entails financing specific assets (e.g. auto loans, credit card receivables, and mortgages) without financing the entire balance sheet. The latter would be the case with the general obligation nature of corporate and sovereign bonds. Secured debt is usually financed via a bankruptcy-remote SPE. This isolation of securitized debt allows:
- higher leverage and lower cost to the issuer
- greater diversification, more stable cash flows
- a higher risk premium relative to similarly related general obligation bonds (due to the higher complexity).
On this page, we discuss the components of secured debt credit analysis.
Credit analysis of structured, securitized debt begins with the collateral pool. Homogeneity of a pool refers to the similarity of the assets within the pool. Granularity refers to the transparency of assets within the pool. A highly granular pool would have hundreds of clearly defined loans, allowing for use of summary statistics as opposed to investigating each borrower. A more-discrete pool of a few loans would warrant examination of each obligation separately.
Different methods are used to evaluate collateral pools:
- Short-term granular and homogenous structured finance vehicles are evaluated using a statistical-based approach
- Medium-term granular and homogenous obligations are evaluated using a portfolio-based approach because the portfolio composition varies over time.
- Discrete and non-granular portfolios have to be evaluated at the individual loan level.
Servicer quality is important to evaluate the ability of the servicer to manage the origination and servicing of the collateral pool. After origination, investors in secured debt face the operational and counterparty risk of the servicer. A servicer’s past history is often used as an indication of servicer quality.
The structure determines the tranching or other management of credit and other risks in a collateral pool. One key structural element is credit enhancement, which may be internal or external:
- examples of internal credit enhancement include tranching of credit risk among classes with differing seniority (i.e. the distribution waterfall), overcollateralization, and excess servicing spread (whereby the such excess or spread becomes the first line of defense against credit losses)
- external credit enhancement is done by third-party guarantees (e.g., bank, insurance companies, or loan originators).
A special structure is the case of a covered bond. Issued by a financial institution, covered bonds are senior, secured bonds backed by a collateral pool as well as by the issuer (i.e., covered bonds investors have recourse rights). Originated in Germany, covered bonds have spread to the rest of Europe, Asia, and Australia.
We compared the credit analysis required for securitized debt. This is quite different from credit analysis of corporate debt