Rating the Credit of Asset-Backed Securities (ABS)
When fixed income securities are issued, the issuer usually seeks a credit rating for its security, since few investors are willing to buy a fixed income security without a credit rating, and even if there were buyers, they would demand a much higher yield to compensate them for their risk.
The credit ratings of bonds depend on the creditworthiness of the issuers and the effectiveness of any external credit enhancements, such as the purchase of bond insurance. In rating a bond, the credit rating agencies have little or no say in the structure of the business or the security, since the corporation is already established with set procedures that enable it to compete effectively in its business. The credit rating of its securities cannot be a main concern, since its main business is to produce a product or to provide a service—the issuance of bonds is simply to help finance the conduct of the business.
However, asset-backed securities are created and issued by a business—the special purpose entity (SPE)—that is created solely to issue securities based on assets, receivables, or loans, and to either remove assets from the balance sheet of the sponsor or to profit from the cash flow difference of income that it receives from the investors of its securities and from the cash flow of its underlying assets, and the expenses that it must pay out.
The profitability of asset-backed securities is largely determined by having a high credit rating, since most of the investors consist of institutional investors who, because they are financial fiduciaries of others, demand or are legally compelled to buy only investment grade securities. A high credit rating also lowers the cost of issuing securities, since it allows the issuers to pay a lower interest rate. To achieve this high rating, the sponsors of asset-backed securities consult with the credit rating agencies to find out what they need to achieve a high rating, then structure the business accordingly, since that is the only business of the issuer of asset-backed securities.
There are 4 major areas that a credit rating agency looks at to determine the creditworthiness of the security:
- the parties to the deal, which includes the sponsors and the management of the issuer;
- legal review of the business and documentation;
- the credit quality of the underlying collateral;
- and the structure of the security itself, including its cash flow and the use of credit enhancements.
The actual people who will be doing the fact finding compose the analytical team consisting of a primary and secondary analyst. The primary analyst manages the process and ensures that deadlines are met in rating a deal. The analytical team gathers all of the information together and presents it a credit committee that usually consists of the analytical team, 2 senior directors, and any others with particular expertise in the particular security. This quorum is necessary to issue any credit rating. If the information is satisfactory, then a credit rating will be issued, but if there are any important questions that cannot be answered at the meeting, then another meeting will be scheduled that will provide enough time for the analysts to gather the information to address the concerns of the committee.
The main types of information considered include:
- the structure of the deal and how it compares with similar structures that were done, both by the sponsor and by other sponsors;
- sponsor/servicer reviews and ratings, including past performance, particularly with similar deals;
- the performance of the collateral pools in other securitizations, especially default and recovery rates;
- underwriting criteria in selecting borrowers;
- geographic diversification of the collateral pool;
- how the deal performs under stress testing, using a number of what-if scenarios that change cash-flow assumptions;
- the effectiveness of the bankruptcy remoteness of the special purpose entity, which will actually securitize and issue the securities;
- the use and effectiveness of credit enhancements to protect the most senior tranche, or class, which will receive the highest credit rating, usually triple-A.
The main determinant of credit quality is the risk of default of the underlying asset and the amount of recovery that is likely after recovery expenses have been paid. This is usually determined by the information that has been gleaned from prior securitizations of the same type of assets. Since most of these assets are based on pools of loans, there is good historical information to accurately quantify both defaults and recovery rates that depend on specific variables. Each specific type of asset has specific variables that help to gauge the credit quality of the asset. For instance, the credit ratings of all assets based on loans obviously depends on the creditworthiness of the borrowers, which, in most cases, is quantified by their credit scores; credit underwriting procedures; and property appraisals, where applicable.
Credit Rating Variables
- For all asset-backed securities based on loans or mortgages.
- underwriting criteria
- borrower credit scores, income, employment history
- annual percentage rate and whether it is fixed or floating
- if floating, the frequency of resetting the floating rate
- seasoning (amount of historical data on default and recovery rates for the type of collateral pool)
- loan type
- geographic diversification
- Mortgage-Backed Securities
- property appraisals
- income verification
- borrower equity in collateral
- lease terms, if applicable
- regional vacancy rates
- management fees
- Credit Card Asset-Backed Securities
- credit card type
- general purpose cards
- examples: VISA, MasterCard
- affinity cards—cards issued for a special interest group, such as those belonging to a college alumni, professional, or sports association.
- cobranded cards—general purpose cards cobranded to a specific merchant, such as the Amazon VISA card.
- independent network cards
- examples: Discover, American Express
- private label cards
- examples: Sears, Wal-Mart
- general purpose cards
- credit card type
- Automobile Loan Asset-Backed Securities
- vehicle age and depreciation
- down payment
- terms and pricing
Review of Main Parties: Servicers, Sponsors, and Asset Managers
The credit rating of asset-backed securities depends on the integrity of the parties involved, such as servicers and asset managers. In assessing these parties, the analyst team will usually visit their company sites for several days, meeting with senior managers, credit analysts, service managers, and others involved in the process, and to actually observe the companies' business procedures and operations. Other parties that may be interviewed include attorneys working on the ABS deal, underwriters who select the borrowers based on their credit criteria, and the trustee, who manages the deal after the securities are sold, for those asset-backed securities that don't require active portfolio management and selection.
The sponsors of asset-backed securities are the creators of the special purpose entity which packages the loans, receivables, or other assets into securities, and the servicers are the companies that actually service the loans or receivables by receiving the payments from the borrowers, providing customer service, and collecting on delinquent accounts. In most cases, the servicers are also the sponsors of the asset-backed securities.
The credit quality of sponsors and servicers, whether separate businesses or the same company, is determined like that of any other business:
- financial condition;
- company and management experience;
- policies, procedures, and operating controls;
- current and projected business;
- the use of technology to reduce costs and improve quality;
- and performance history, especially in regard to the assets being used as collateral.
Asset managers are an important consideration for those securities, such as collateralized debt obligations (CDOs), where the asset manager has an important role in selecting the securities, managing the portfolio, and monitoring its credit quality. To maintain credit ratings, the asset manager must perform various credit quality tests periodically, and if any of the tests fail, the manager must take steps to protect investors. The main criteria of the initial credit rating is dependent on the manager's experience, especially with the underlying collateral; the selection of assets and the credit underwriting procedures for the underlying assets. Ongoing reviews of credit status will depend of the CDO's administration, and the management and performance of the portfolio.