Question

Is the correlation of fixed rate loans important in determining the level of credit enhancement? Why or why not?

Answer 1

The concept of Credit Enhancement is predicated on two elements - the Weighted Average Loss Severity and Weighted Average Foreclosure Frequency.

The Weighted Average Loss Severity (WALS) is the loss expected as a percentage of the loan amount, given a default occurs.

The Weighted Average Foreclosure Frequency (WAFF) represents the likelihood a borrower will default on a loan. In short, WAFF is the proxy for the quality of lending practices and the overall state of the economy.

There is a correlation in the economy between defaults and fixed-rate loans, In a weak economy, you would expect to see defaults increase and fixed-rate loans decrease at the same time.

CE = WALS * WAFF

So, in short, correlation is an important part in determining the level of credit enhancement.