Asset-backed security

An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized (or "backed") by a specified pool of underlying assets.

The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can vary from common payments on credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments, or movie revenues.

Often a separate institution, called a special-purpose vehicle, is created to handle the securitization of asset-backed securities. The special-purpose vehicle, which creates and sells the securities, uses the proceeds of the sale to pay back the bank that created, or originated, the underlying assets.

The special-purpose vehicle is responsible for "bundling" the underlying assets into a specified pool that will fit the risk preferences and other needs of investors who might want to buy the securities, for managing credit risk – often by transferring it to an insurance company after paying a premium – and for distributing payments from the securities. As long as the credit risk of the underlying assets is transferred to another institution, the originating bank removes the value of the underlying assets from its balance sheet and receives cash in return as the asset-backed securities are sold, a transaction which can improve its credit rating and reduce the amount of capital that it needs. In this case, a credit rating of the asset-backed securities would be based only on the assets and liabilities of the special-purpose vehicle, and this rating could be higher than if the originating bank issued the securities because the risk of the asset-backed securities would no longer be associated with other risks that the originating bank might bear. A higher credit rating could allow the special-purpose vehicle and, by extension, the originating institution to pay a lower interest rate (and hence, charge a higher price) on the asset-backed securities than if the originating institution borrowed funds or issued bonds.

Thus, one incentive for banks to create securitized assets is to remove risky assets from their balance sheet by having another institution assume the credit risk, so that they (the banks) receive cash in return. This allows banks to invest more of their capital in new loans or other assets and possibly have a lower capital requirement.

Definition

An "asset-backed security" is sometimes used as an umbrella term for a type of security backed by a pool of assets,[1] and sometimes for a particular type of that security – one backed by consumer loans or loans, leases or receivables other than real estate.[2] In the first case, collateralized debt obligations (CDO, securities backed by debt obligations – often other asset-backed securities) and mortgage-backed securities (MBS, where the assets are mortgages), are subsets, different kinds of asset-backed securities. (Example: "The capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs". (italics added)). In the second case, an "asset-backed security" – or at least the abbreviation "ABS" – refers to just one of the subsets, one backed by consumer-backed products, and is distinct from a MBS or CDO, (example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO .... Securitization issues backed by consumer-backed products – car loans, consumer loans and credit cards, among others – are called ABS[3][4]

Structure

United States

On January 18, 2005, the United States Securities and Exchange Commission (SEC) promulgated Regulation AB which included a final definition of Asset-Backed Securities.[5]

According to Thomson Financial League Tables, US issuance (excluding mortgage-backed securities) was:

"Definition of ABS. The term "asset-backed security" is currently defined in Form S-3 to mean a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holders. The SEC has interpreted the phrase "convert into cash by their terms" to exclude most assets that require active behavior to acquire cash – such as the selling of non-performing assets and physical property. It has also interpreted the phrase "discrete pool" to exclude those that can change in composition over time.

Types

Home equity loans

Securities collateralized by home equity loans (HELs) are currently the largest asset class within the ABS market. Investors typically refer to HELs as any nonagency loans that do not fit into either the jumbo or alt-A loan categories. While early HELs were mostly second-lien subprime mortgages, first-lien loans now make up the majority of issuance. Subprime mortgage borrowers have a less-than-perfect credit history and are required to pay interest rates higher than what would be available to a typical agency borrower. In addition to first- and second-lien loans, other HE loans can consist of high loan to value (LTV) loans, re-performing loans, scratch and dent loans, or open-ended home equity lines of credit (HELOC), which homeowners use as a method to consolidate debt.[6]

Auto loans

The second-largest subsector in the ABS market is auto loans. Auto finance companies issue securities backed by underlying pools of auto-related loans. Auto ABS are classified into three categories: prime, nonprime, and subprime: Owner trusts are the most common structure used when issuing auto loans and allow investors to receive interest and principal on sequential basis.

Trading asset-backed securities

"In the United States, the process for issuing asset-backed securities in the primary market is similar to that of issuing other securities, such as corporate bonds, and is governed by the Securities Act of 1933, and the Securities Exchange Act of 1934, as amended. Publicly issued asset-backed securities have to satisfy standard SEC registration and disclosure requirements, and have to file periodic financial statements."[9]

"The Process of trading asset-backed securities in the secondary market is similar to that of trading corporate bonds, and also to some extent, mortgage-backed securities. Most of the trading is done in over-the-counter markets, with telephone quotes on a security basis. There appear to be no publicly available measures of trading volume, or of number of dealers trading in these securities."[9]

"A survey by the Bond Market Association shows that at the end of 2004, in the United States and Europe there were 74 electronic trading platforms for trading fixed-income securities and derivatives, with 5 platforms for asset-backed securities in the United States, and 8 in Europe."[9]

"Discussions with market participants show that compared to Treasury securities and mortgage-backed securities, many asset-backed securities are not liquid, and their prices are not transparent. This is partly because asset-backed securities are not as standardized as Treasury securities, or even mortgage-backed securities, and investors have to evaluate the different structures, maturity profiles, credit enhancements, and other features of an asset-backed security before trading it."

Securitization

Securitization is the process of creating asset-backed securities by transferring assets from the issuing company to a bankruptcy remote entity. Credit enhancement is an integral component of this process as it creates a security that has a higher rating than the issuing company, which allows the issuing company to monetize its assets while paying a lower rate of interest than would be possible via a secured bank loan or debt issuance by the issuing company.

ABS indices

On January 17, 2006, CDS Indexco and Markit launched ABX.HE, a synthetic asset-backed credit derivative index, with plans to extend the index to other underlying asset types other than home equity loans.[10] ABS indices allow investors to gain broad exposure to the subprime market without holding the actual asset-backed securities.

Advantages and disadvantages

A significant advantage of asset-backed securities for loan originators (with associated disadvantages for investors) is that they bring together a pool of financial assets that otherwise could not easily be traded in their existing form. By pooling together a large portfolio of these illiquid assets they can be converted into instruments that may be offered and sold freely in the capital markets. The tranching of these securities into instruments with theoretically different risk/return profiles facilitates marketing of the bonds to investors with different risk appetites and investing time horizons.

Asset-backed securities provide originators with the following advantages, each of which directly adds to investor risk:

This risk is measured and contained by the lender of last resort from time to time auctions and other Instruments that are used to re-inject the same bad loans held over a longer time duration to the appropriate buyers over a period of time based on the instruments available for the bank to carry out its business as per the business charter or the licensings granted to the specific banks. The risk can also be diversified by using the alternate geographies, or alternate vehicles of investments and alternate division of the bank, depending on the type and magnitude of the risk.

The exposure of these refinanced loans to "bad credit" (Type II) decisions (particularly in the banking sector, unscrupulous lending or the adverse selection of credits) is hedged against by the sellers of the same, or the re-structurers of the same. Thinking of securitization (insurance) as a panacea for all the ills of bad credit decisions might lead to the hedging of the risk by the transfer of the "hot potato" from one issuer to another without the actual asset against which the loan is backed reaching an upswing in value, either by the demand-supply mismatch being addressed or by one of the following factors: On a day-to-day basis the transferring of the loans from the Senior as well as bad (securitized) debt might be a better way to distinguish between the assets that might require or be found eligible for re-insurance or write – off or impaired against the assets of the collaterals or is realized as a trade-off of the loan granted against or the addition of goods or services.

Government bailouts

The US government has provided relief to the ABS industry through Term Asset-Backed Securities Loan Facility (TALF) during the Great Recession of 2008 and the COVID-19 pandemic.[11][12]

External links

Leading Investment Bankers in the Asset-Backed Securities Market, according to Asset-Backed Alert
Asset Backed Securities Video produced by DW (Deutsche Welle)
Difference between nonrecourse stock loans and legitimate securities-collateralized lending

References

assets that otherwise could not be traded has been securitized. MBS and CDO compared: an empirical analysis^
Asset-Backed Security – ABS Investopedia, retrieved 14 July 2013^
Dennis Vink. ABS, MBS and CDO compared: an empirical analysis August 2007, Munich Personal RePEc Archive, retrieved 13 July 2013