An asset-backed security has been credit enhanced with a letter of credit from a bank with a single A credit rating

Question

If this is the only form of credit enhancement, explain whether this issue can be assigned a triple A credit rating at the time of issuance.

Answer 1

The issue will not receive a triple A credit rating but a single A credit rating because there are no other forms of credit enhancements such as reserve funds (cash reserves and excess servicing spread) and overcollateralization. More details are given below.

In the earlier credit card structures, the most popular form of credit enhancement was a bank letter of credit. However, the disadvantage of a third-party guarantee is that if the guarantor is downgraded the structure will be downgraded regardless of how the collateral is performing. With the downgrading of banks that provided letters of credit for earlier credit card deals and the subsequent downgrading of the securities, this form of credit enhancement lost its popularity.

Today the two most popular forms of credit enhancement for credit card deals coupled with any senior/subordinated structure are the cash collateral account and the collateral invested account. Both forms of credit enhancement involve the investment of cash. In the case of the cash collateral account, funds are generally borrowed from a bank and those funds are then invested in commercial paper or other short-debt of the bank. In the collateral invested account, the funds are invested in credit card receivables within the structure rather than commercial paper or other short-term debt.