Credit Enhancement: What Actually Protects a Top Piece

Credit enhancement is whatever absorbs a shortfall before a given piece has to. In this structure only one form of it is present, and that form is the order of absorption itself. Beneath the senior piece sit Rs 240 crore belonging to other holders. Set against the Rs 1,200 crore pool, that is 20.0 per cent. The two pieces underneath supplied all of it. Nothing arrived from outside.

Everything after this paragraph is an elaboration of one awkward fact. A piece of a structure is exposed to a pool of loans it cannot manage, cannot call in and cannot inspect one borrower at a time. So the only thing that stands between that piece and a bad month in the pool is whatever has agreed, in advance and in writing, to take the hit earlier. The agreement to take the hit earlier is credit enhancement, and the useful question about any of it is never whether it exists. The useful question is two questions, asked in this order: how much is it in rupees, and which party gave that amount up?

What is credit enhancement, as an amount rather than a feature?

Start by refusing the word as an adjective. A structure does not become enhanced the way a phone camera does. Nothing about the receivables improves, no borrower repays more reliably, and no instalment becomes larger because somebody wrote the phrase into a document. Credit enhancement is a quantity of loss absorption placed ahead of a particular piece, and the whole of its content is a number of rupees with a name attached to who provides it.

Sarvani Receivables Trust, an invented securitisation structure, holds a pool of receivables worth Rs 1,200 crore. Three amounts fund that pool. Rs 960 crore was raised as the senior piece. The mezzanine piece accounts for Rs 180 crore. Rs 60 crore came in as the equity piece, and those three amounts are the entirety of the funding. A shortfall in the pool reaches the equity piece before it reaches anything else. Only when that piece has nothing left does the mezzanine piece begin to take any of it. The senior piece waits behind both of them.

Turn that order into rupees and the senior piece's enhancement is Rs 240 crore, the mezzanine piece's is Rs 60 crore, and the equity piece's is Rs 0/-. The three figures are the whole subject in miniature. Everything else here either explains where they came from, checks them, or marks out what they refuse to say.

The third of those figures is worth pausing on. Nothing at all stands in front of the equity piece, on any base, under any reading. The Rs 0/- is not a defect in the structure and it is not an oversight by whoever wrote it. Absorption that everybody avoids is absorption nobody has agreed to, so somebody has to stand at the front. A structure without that somebody would simply be a pool with three unrelated claims on it. The equity piece is the party that agreed to be first, and the price of that agreement is the entire subject of this guide.

Where did the senior piece's Rs 240 crore come from?

Following the money produces something slightly deflating: it does not come from anywhere new. The equity piece of Rs 60 crore added to the mezzanine piece of Rs 180 crore is Rs 240 crore, and both of those amounts are already sitting inside the Rs 1,200 crore that funds the pool. No cheque was written. No originatorThe lending business whose loans these originally were, and which afterwards sold them into the structure. What it does before the sale, and how it decides to lend at all, is settled elsewhere. topped anything up. No third party stepped forward. The holders of the two lower pieces supplied every rupee of the senior piece's protection, and the only thing they supplied it with was their agreement to be reached first.

The drawing below therefore shows the enhancement as the two lower pieces rather than as a separate block beside them. A separate block would look like an extra resource, and that is the most convincing kind of lie. There is no extra resource. There is a sequence, and a sequence costs nothing to write down while costing a great deal to be at the wrong end of.

There is a household version of this that lands faster than any diagram. Two people share a scooter. The two agree that if the scooter is scratched, the one who rides it on weekends pays for the repair first, and only what is left over is split. The weekday rider now has protection. Nobody bought insurance, nobody set aside a repair fund, and the scooter is exactly as scratchable as it was on the day they bought it. The protection is an agreement about sequence, and the weekend rider paid for it by accepting the sequence.

How much does each piece have, and against what base?

Now the figures, and each one printed twice. The senior piece has Rs 240 crore beneath it. Divided by the Rs 1,200 crore pool, that is 20.0 per cent. The same Rs 240 crore divided by the senior piece's own Rs 960 crore is 25.00 per cent. The mezzanine piece has Rs 60 crore beneath it. On the pool as base that is 5.0 per cent, and on the mezzanine piece itself it is 33.3333 per cent. The equity piece has nothing beneath it. Zero divided by anything is still zero, so the figure stays Rs 0/- on either base.

The same enhancement looks small measured on the pool and large measured against whichever piece it protects, so a percentage quoted without naming its base can be argued in either direction by anybody who wants to. Twenty against twenty five is not a dramatic spread. Five against thirty three is, and the second pair is the same Rs 60 crore in both readings. A structure described as having a third of protection behind a piece has said almost nothing until the question a third of what has been asked.

The base discipline goes further than protection figures. Take a plain event: the pool falls short by Rs 60 crore. Described against the pool that is 5.0 per cent. The equity piece is Rs 60 crore and has just been taken out completely, so described against the equity piece the same event is 100.0 per cent. The two descriptions cover one event on one day. A reader shown 5.0 per cent shrugs. A reader shown 100.0 per cent sits up. Neither reader has been misled and neither has been told the whole thing. So every ratio in this guide names the amount it was divided by, every single time.

What are the five forms, and which of them is present here?

Credit enhancement comes in five recognisable shapes, and it helps to have all five in view before deciding which of them a particular structure carries.

The first is subordination. Subordination is the order of absorption itself, and it is the one form Sarvani Receivables Trust runs on. The second is overcollateralisation. The pool is deliberately made larger than the amounts funding it, so a shortfall eats the difference before it reaches any funder at all. The third is excess spread, where what the pool collects in interest exceeds what the pieces and the running costs consume, leaving a surplus each period that absorbs before anything else does. The fourth is a reserve account, where a sum is set aside at the start and drawn down before any piece is touched. And the fifth is an outside promise, where a party that is not part of the structure agrees to meet a shortfall if one arrives.

Sarvani Receivables Trust carries exactly one of the five, and the honest thing to do with the other four is to mark each of them Rs 0/- rather than to describe them attractively and leave the reader guessing. There is no larger pool than the funding, so overcollateralisation contributes nothing. No interest rate is stated on the pool or on any piece anywhere in this material, so no excess spread can be computed and none is implied. No sum has been set aside, so the reserve account line is empty. And no party outside the structure appears anywhere, so there is nothing to price as an outside promise. Four zeroes, arrived at by looking rather than by assuming.

Naming a form without a figure beside it is the quiet way a description misleads. The mind adds up things it has been shown even when it was never told they were present, so a paragraph that lists five kinds of protection and describes each one well leaves an impression of a well-cushioned structure. The figure column is what prevents that. Four of these rows are empty, and they are shown empty.

Why is there no overcollateralisation here at all?

The question can be settled with an addition a schoolchild can run. Rs 960 crore plus Rs 180 crore plus Rs 60 crore is Rs 1,200 crore. The pool is Rs 1,200 crore. The two figures are the same figure, so the difference between them is Rs 0/-, and a difference of Rs 0/- has nothing in it for a shortfall to eat before reaching a funder.

Overcollateralisation, put plainly, is a pool worth more than the money raised against it. Suppose a lending business sold Rs 1,320 crore of receivables into a structure and raised only Rs 1,200 crore against them. The extra Rs 120 crore of receivables would belong to the structure, would have no funder claiming it, and would therefore be consumed first by any shortfall. Somebody handed over more assets than they took cash for, and the extra Rs 120 crore is therefore a genuine cushion and genuinely extra.

The test is a subtraction, it takes ten seconds, and it is the first thing worth running on any structure before reading a single descriptive word about its protection. The pieces are added and the total set against the pool. If the pool is larger, the difference is real overcollateralisation and its size can be named. If the two are equal, as they are here, then whatever protection exists in that structure came out of the ordering and out of nothing else.

Can two forms of enhancement be added together?

Sometimes, and the condition is simple to state and easy to violate. Two forms add when a shortfall would genuinely have to consume both of them. Suppose a structure had set Rs 40 crore aside in a reserve at the start, and separately had Rs 100 crore of pieces ranked below the one being held. A shortfall works through the reserve, exhausts it, and then starts on the pieces below. The shortfall meets both. Rs 140 crore is a true statement about what stands in front of that piece.

The same money entered twice under two names never adds, and that double count is the commonest error anybody makes on this subject. If the Rs 40 crore reserve was funded by the equity holder as part of that same Rs 100 crore, then counting it separately counts one contribution twice, and the honest figure stays Rs 100 crore. The test is not whether two labels exist. The test is whether two distinct pots of money exist, each of which a shortfall would have to work through in turn.

There is a second version of the same error, less obvious and more common in writing than in arithmetic: treating a form that is absent as though it were present. A careful description of excess spread, in a structure where no interest rate is stated anywhere, has effectively added an unknown amount to the reader's mental total. In Sarvani Receivables Trust the four absent forms contribute Rs 0/- each, so the arithmetic is short. Rs 240 crore plus four zeroes is Rs 240 crore, and any total larger than that has counted something this structure does not contain.

Does any of this reduce what the pool loses?

Credit enhancement reduces nothing, and that single fact is worth carrying away from the whole guide. Suppose the pool falls short by 28.0 per cent. On Rs 1,200 crore that is Rs 336 crore. Worked through the order, the equity piece takes Rs 60 crore and is gone. The mezzanine piece takes Rs 180 crore and is gone. The remainder is Rs 336 crore less Rs 240 crore, or Rs 96 crore. Rs 96 crore lands on the senior piece and amounts to 10.0 per cent of its own Rs 960 crore. The three absorptions added back are Rs 60 crore plus Rs 180 crore plus Rs 96 crore. The total is Rs 336 crore.

The three destinations add back exactly to the shortfall they started from, and that addition is the arithmetic proof that nothing was absorbed away. Enhancement is a routing instruction. A routing instruction decides which holders find out about a bad pool and in what order, and it changes the size of nobody's problem in aggregate by a single rupee. The pieces are claims on the pool, and the pool is the only thing that generates money, so no arrangement of pieces ever could.

What does the same mechanism look like with a rented flat?

Three people share a flat and lodge a deposit of Rs 90,000/- with the landlord, Rs 30,000/- each. Before moving in they write one extra sentence into their own agreement: any damage is charged against the third flatmate's share first, then against the second's, and only then against the first's.

Look at what that sentence did and did not do. The first flatmate now has Rs 60,000/- standing in front of their money. Against the whole Rs 90,000/- deposit that is 66.67 per cent. Nobody put another rupee into it. The landlord holds Rs 90,000/- today just as before. The windows are exactly as breakable as they were, the geyser is exactly as likely to leak, and if the flat is wrecked to the tune of Rs 90,000/- then Rs 90,000/- has gone regardless of the sentence. The one sentence changed who finds out about a broken window, and in what order.

The one thing the flat example does not carry is the size difference. The three shares there are equal thirds. Sarvani Receivables Trust splits its funding into Rs 960 crore, then Rs 180 crore, then Rs 60 crore, so the party standing at the front is much the smallest of the three. The asymmetry is the interesting part of a real structure, and it is why the equity piece is wiped by a shortfall of 5.0 per cent when measured on the pool while the senior piece is untouched by the same event.

How does anybody actually use this?

Give an analyst a structure and a claim about how well protected a piece is, and there is a short routine that separates a real cushion from a described one. The routine runs in three moves and needs nothing but the amounts.

Every one of those three moves is arithmetic on figures a document already contains, and all three are worth running before any descriptive language about a structure is read at all. A household version exists too. A chit arrangement described as protected because three other members would absorb a shortfall first raises the same three questions: how much are those three shares worth, did the three actually put that money in, and how large is it against the member's own contribution rather than against the whole arrangement. The vocabulary changes and the routine does not.

One caution about that routine. Every move above concerns the destination of a shortfall. Not one of them says anything about whether a shortfall will occur, how large it might be, or how often. The routine is complete as far as it goes and it goes only that far.

What does the enhancement figure not establish?

Here is the boundary, stated at exactly the point where a reader expects the missing thing to arrive. Enhancement settles where a shortfall comes to rest, and that destination has been shown precisely: Rs 240 crore of pool shortfall lands on somebody other than the senior piece before a rupee of it reaches the senior piece. Whether a shortfall of any size turns up in the first place is a completely separate question, and answering it needs a frequency that nobody has put behind these figures.

The gap is not an omission to be apologised for. Four amounts and one order are all a structure of this kind fixes. A likelihood needs three further things: a distribution of losses across the pool, a view on whether the receivables go wrong together or one at a time, and a schedule of the periods over which any of it happens. Without those three things there is no honest way to attach a likelihood to anything. An assessment, a probability and the word safe all rest on those three things, so an order of absorption on its own can never deliver one.

Notice how easily the step gets taken anyway. A reader learns that the senior piece is reached last, hears that as a statement about safety, and moves from safety to a view about whether that piece is worth holding, all in about two seconds and without a single figure changing hands. The order fixes which holder is reached ahead of which. The order carries nothing at all about how often any of them is reached, and four amounts cannot supply that either.

The servicerThe party that collects instalments from the underlying borrowers and passes the money into the structure. Its duties are covered separately. collecting on the pool, the trusteeThe party that holds the structure on behalf of the note holders and acts for them under the documents. What it must do is a matter of duty rather than of arithmetic. holding it for the note holders, and the holder of any pass-through certificateThe instrument evidencing a share in what a structure collects and pays out. How it is taxed and how it is dealt in are settled by the authorities named below. issued by a special purpose vehicleA standalone entity set up to hold a pool and nothing else, so that the pool's fortunes are kept apart from those of whoever originally made the loans. all read the same Rs 240 crore figure and each of them wants something different from it. Rs 240 crore is not that kind of number, so not one of them can get a probability out of it.