insurance provides the same function as in municipal bond structures. The major insurers are AMBAC, MBIA, FSA, and FGIC. A nonagency CMO with external credit support is subject to the credit risk of the third-party guarantor. Should the third-party guarantor be downgraded, the issue itself could be subject to downgrade even if the structure is performing as expected. This is based on the "weak link" test followed by rating agencies. According to this test, when evaluating a proposed structure, the credit quality of the issue is only as good as the weakest link in credit enhancement regardless of the quality of the underlying loans. This is the chief disadvantage of third-party guaran- tees, sometimes referred to as "event risk." Therefore, it is imperative that investors monitor the third-party guarantor as well as the collateral. External credit enhancements do not materially alter the cash flow characteristics of a CMO structure except in the form of prepayments. In case of a default resulting in net losses within the guarantee level, investors will receive the principal amount as if a prepayment has occurred. If the net losses exceed the guarantee level, investors will real- ize a shortfall in the cash flows.   Internal Credit Enhancements Internal credit enhancements come in more complicated forms than exter- nal credit enhancements and may alter the cash flow characteristics of the loans even in the absence of default. The most common forms of internal credit enhancements are reserve funds and senior/subordinated structures. Reserve funds come in two forms, cash reserve funds and excess ser- vicing spread. Cash reserve funds are straight deposits of cash generated from issuance proceeds. In this case, part of the underwriting profits from the deal are deposited into a fund which typically invests in money mar-     ket instruments. Cash reserve funds are typically used in conjunction with letters of credit or other kinds of external credit enhancements. Excess servicing spread accounts involve the allocation of excess spread or cash into a separate reserve account after paying out the net coupon, ser- vicing fee, and all other expenses on a monthly basis. For example, suppose that the gross WAC is 7.75%, the servicing and other fees are 0.25%, and the net WAC is 7.25%. This means that there is excess servicing of 0.25%. The amount in the reserve account will gradually increase and can be used to pay for possible future losses. This form of credit enhancement relies on the assumption that defaults occur infrequently in the very early life of the loans but gradually increase in the following two to five years. The most widely used internal credit enhancement structure is the senior/subordinated structure. Today a typical structure will have a senior tranche and several junior tranches. The junior tranches represent the