over-collateralization, credit enhancements

[shanlane]

Hello,

In the Culp reading, there is a strange example he gives involving holdback and equity.

He first says that direct equity issue is Credit enhancement or a form of OC . So if we issue 80MM in debt and 20MM in equity on 100MM in assets, the debt issue has 20MM in CE. That makes perfect sense.

Then he describes holdback and says that if we purchase something for less than it is worth, we also have CE. Then the numbers get strange and possibly wrong. He says that if we sell 80MM of debt and 1MM in equity to purchase 100MM of assets for 81MM that the debt issue only has 19MM in CE. Wouldnt it be 20MM since the equity issue is also considered CE?

Am I missing something?

Thanks!

Shannon

 

[David Harper CFA FRM]

Hi Shannon,

I've never noticed that but I agree, so if you are missing something, then so am I. He has a holdback of 19 (100 - 81), but the equity is also credit enhancement to the debt, so I can't figure out any other way to interpret it: $19 holdback + $1 direct equity = $20 O/C for the entire and only "senior" debt.

Well, the only other interpretation i can see, but I am just reading into it, is: the $1 in external equity is somehow diluted into the 19% holdback, such that internal+external equity = 19%, but I'm just making that up. I think he made a mistake. (or he made an assumption about the dilution of the 1% that he did not explain).

David