Asset-backed securities (ABS) are bonds backed by financial ‘assets’ such as loans, receivables, etc. They are issued through a process of securitization in which a special purpose entity (SPE) is incorporated, the financial assets are transferred to that entity which use them as collateral for the asset-backed securities that it issues.
The financial assets referred above which are transferred to the special purpose vehicle are called securitized assets. Typical securitized assets include mortgages, receivables, student loans, credit card debt, etc. The entity which transfers the securitized assets to the SPE is called the originator and the parties who are obligated to pay back the pooled assets are called servicers.
Mortgage-backed securities, auto loans ABS, credit card receivables ABS, student loans ABS, etc. are some major types of asset-backed securities.
Mortgage-backed securities: The amortizing asset-backed securities which are backed by mortgages are called mortgage-backed securities (MBS) which are further classified into residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (RMBS). Mortgages are amortizing loans made for and collateralized by real estate. MBS are a subset of the ABS. Mortgage-backed securities which are issued by government agencies are called agency MBS and other mortgage-backed securities are called non-agency MBS.
Auto loans ABS are backed by auto loans and are also amortizing in nature.
Credit card ABS are backed by credit card receivables and are non-amortizing in nature.
There are two main risks relevant to asset-backed securities: credit risk and prepayment risk.
Credit risk is that the risk that the issuer of the asset-backed securities i.e. the special purpose vehicle may default on its payments. The credit risk in an ABS is managed by creating different credit tranches i.e. different bonds with different exposure to credit risk because one bond is senior to the other. The senior tranches have higher credit rating and vice versa.
Prepayment risk is the risk that people will prepay their mortgages in low interest environment thereby returning the principal early. The prepayment risk is managed by creating different (time) tranches in an ABS each with different exposure to prepayment risk.
Let’s consider Bank ABC which has a portfolio of auto loans worth $50 million. It may create a trust (let’s call it SPE 1) which is typically a bankruptcy remote entity i.e. its assets and liabilities are separate from the bank in legal sense and transfer the loans portfolio to that trust. It can dissect the loan portfolio based on their final maturity date and their credit risk and create four difference securities as follows:
|ABS 1||4.50%||$10 million||Low||3+ years|
|ABS 2||5.00%||$15 million||Moderate||3+ years|
|ABS 3||3.00%||$12 million||Low||up to 3 years|
|ABS 4||3.20%||$13 million||Moderate||up to 3 years|
The above table shows that the auto loans pool is cut into different slices each with different credit risk and prepayment risk which enables different investors to choose the credit risk exposure they want to take and match the maturity of their investments with their liabilities.
The bank will receive the proceeds of the ABS and use them to make further loans. The asset-backed securities allow investors to access a market which is otherwise not efficiently accessible by them and create more loanable funds. This is how ABS are useful.