Asset-Backed Security (ABS)

What are asset-backed securities (ABS)?

Asset-backed securities (ABS) are a type of financial security backed by a pool of assets, such as auto loans, credit card receivables, mortgage-backed securities, and other types of bank loans. These assets generate cash flows in the form of interest and principal payments, which are then passed on to ABS investors.

The process of creating asset-backed securities involves securitization, where financial institutions convert illiquid assets, such as residential mortgages, auto loans, and credit card debt, into liquid, tradable securities. This allows financial institutions to remove risky assets from their balance sheets and free up capital for lending to other borrowers.

The underlying asset pool is typically grouped by the financial institution based on the type of asset and its credit risk. The pool of assets is then transferred to a special purpose vehicle (SPV), which issues the ABS to institutional investors, such as pension funds, mutual funds, and insurance companies.

ABS are part of the fixed-income sectors and are considered fixed-income securities. They offer investors a steady stream of cash flows generated from the underlying assets. The cash flows are typically paid monthly and include both interest and principal payments.

Disadvantages

1. Lack of Due Diligence. ABS can contain hundreds of underlying loans, making it difficult for investors to evaluate the credit risk of each asset without extensive research. For retail investors, it may not be possible to conduct such a level of due diligence, exposing them to unforeseen risks.

2. Lower Yield from Prepayments. ABS may be subject to prepayment risks, which occur when borrowers of the underlying loans decide to pay off their loans early. This can result in a lower yield for holders of the ABS.

3. Potential Widespread Defaults During an Economic Downturn. If the underlying loans are of low quality, ABS can suffer from widespread defaults during economic downturn. This can lead to significant losses for investors, especially if they have not conducted proper due diligence.

Asset-backed securities explained

Asset-backed securities (ABS) are a type of financial security backed by a pool of underlying assets, such as home equity loans, automobile loans, credit card receivables, student loans, or other expected cash flows. The issuer of an ABS pools together these illiquid assets and creates a financial instrument out of them through a process called securitization. This allows the issuer to raise cash, which can be used for lending or other investment purposes, and also to alleviate their credit risk by getting shakier assets off their books.

ABS issuers can be creative in the types of assets that they securitize, and just about any cash-producing vehicle or situation can be securitized into an ABS. For example, ABS have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics.

For investors, buying an ABS provides the opportunity for a revenue stream. By participating in a wide variety of income-generating assets, sometimes exotic ones that aren't available in any other investment, investors can benefit from a diversified cash flow stream. The underlying assets of an ABS generate cash flows, which are then passed on to the investors as payments. These payments may include interest and principal repayments, as well as other origination fees and charges associated with the underlying assets.

Types of asset-backed securities

1. Home Equity Loans. Securities collateralized by home equity loans (HELs) are currently the largest asset class within the ABS market. First-lien loans now make up the majority of issuance, while early HELs were mostly second-lien subprime mortgages. Other HE loans can consist of high loan-to-value (LTV), re-performing loans, scratch and dent loans, or open-ended home equity lines of credit (HELOC).

2. 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.

3. Credit Card Receivables. Securities backed by credit card receivables have been a benchmark for the ABS market since they were first introduced in 1987. A credit card holder may borrow funds on a revolving basis up to an assigned credit limit. ABS backed by credit card receivables are issued out of trusts that have evolved over time from discrete trusts to various types of master trusts.

4. Student Loans. ABS collateralized by student loans (“SLABS”) comprise one of the four core asset classes financed through asset-backed securitizations. Federal Family Education Loan Program (FFELP) loans are the most common form of student loans and are guaranteed by the U.S. Department of Education. A second, and faster-growing, portion of the student loan market consists of non-FFELP or private student loans.

5. Other Assets. Other types of asset-backed securities include stranded cost utilities, such as rate reduction bonds (RRBs), and other cash-flow-producing assets, including manufactured housing loans, equipment leases and loans, aircraft leases, trade receivables, dealer floor plan loans, securities portfolios, and royalties. Intangibles are another emerging asset class.

Example

A collateralized debt obligation (CDO) is an example of an asset-backed security (ABS) that is backed by a diversified pool of debt obligations, such as corporate bonds, residential mortgage loans, commercial mortgage loans, and other types of debt securities. The CDO is structured into different tranches with varying levels of credit risk and returns, allowing investors to choose the level of risk they are willing to take on.

For example, suppose a CDO is created with a pool of $100 million in residential mortgage loans. The CDO is then divided into three tranches: a senior tranche with $60 million in loans, a mezzanine tranche with $30 million in loans, and a junior tranche with $10 million in loans. The senior tranche has the lowest level of risk and receives the lowest interest rate, while the junior tranche has the highest level of risk and receives the highest interest rate.

The monthly mortgage payments from the underlying pool of loans are used to pay interest to the investors in the CDO. If any of the loans in the pool default, the losses are first absorbed by the junior tranche, followed by the mezzanine tranche, and finally the senior tranche. This structure provides credit enhancement to the senior tranche, making it a more attractive investment for risk-averse investors.