In securitization, credit enhancement refers to a risk-reduction technique that increases the credit profile of structured financial products or transactions. Credit enhancement may be divided into First Loss facility and Second Loss facility.
First loss facility represents the first level of financial support to a special purpose vehicle (SPV) as part of the process in bringing the securities issued by the SPV to investment grade. The provider of first loss facility (third party) agrees to insure holders tradable debt securities issued by SPV for a given amount or percentage of any losses from the asset pool. The provider of this facility bears the bulk (or all) of the risks associated with the assets held by the SPV.
Second Loss Facility: When a first loss facility does not provide substantial cover, a second loss facility is providing a second (or subsequent) tier of protection to an investor, SPV and others against potential losses. Second loss facility covers only losses beyond those covered by the first loss facility. In the other words, this is in addition to the cover provided under the first loss facility.
The object of first loss facility is to ensure the pool of assets securitised get the bare minimum investment grade rating, whereas the second loss facility is an additional cushion for obtaining a higher rating for the tradable securities.
Treatment of First Loss Facility: The first loss credit enhancement provided by the originator shall be reduced from capital funds and the deduction shall be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised. The deduction shall be made 50% from Tier 1 and 50% from Tier 2 capital.
Treatment of Second Loss Facility: The second loss credit enhancement provided by the originator shall be reduced from capital funds to the full extent. The deduction shall be made 50% from Tier 1 and 50% from Tier 2 capital.
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