Internal credit enhancements
1.reserve funds,
overcollateralization,
senior/subordinated structure.
1 and 2 are easy to understand. But why 3. senior/subordinated structure belong to internal credit enhancements as well. I think it just reallocate the credit risk. Do not see any enhancement here…
The subordinate enhances the senior since it absorbs losses first
For me…when you are going to
1)a bank (letter of credit)…
2)an Insurer for bond insurance
3)a third party
for additional protection to enhance your credit rating…we call it external credit enhancement…
drawbacks of this are 1)too costly 2)you are depended on the credit quality of external 3rd party.
In senior subordinated structure you are not going to a external party for credit enhancement .subordinated structures receiving most or all of the losses. thus protecting the senior tranches.