Asset-Backed Securities (ABS)
Asset-backed securities (ABS) are securities like bonds that pay periodic interest until maturity, when the principal is paid back. The income from ABS is derived from pools of loans and receivables that have been securitized into the ABS. First issued in 1985, the total ABS issued each year has been growing ever since.
Types of asset-backed securities include the following:
- Consumer loans and receivables
- Mortgage loans
- home-equity loans
- manufactured housing contracts
- student loans
- credit card receivables
- auto, boat, recreational vehicle loans
- Business receivables
- trade receivables
- dealer-floor plan receivables
- equipment leases.
Because financial engineering can create securities out of virtually any cash flow, there will probably be many more asset-backed securities in the future.
Because of the large, well-established market for mortgage-backed securities (MBS), ABS based on 1st mortgages are considered a separate investment category. Of the other asset-backed securities, home equity loans, auto loans, credit card receivables, and student loans currently constitute more than 80% of the ABS market.
The sponsors of ABS are the originators of the loans and receivables. Common sponsors include banks, finance companies, and credit card issuers.
Pools of loans are sold to special investment vehicles (aka SIV, special purpose entity, SPE, special purpose vehicle, SPV), which are usually corporations or other business entities whose sole purpose is to securitize the loans, then sell them to a trust. Using SIVs as an intermediary between the sponsor of the ABS and the issuing trust provides bankruptcy remoteness to the trust. Sometimes, however, the ABS sponsor sells the loans directly to the trust.
The trust is the actual issuer of the ABS, and the trust is usually organized according to the type of the underlying collateral:
- A grantor trust is used for the issuance of pass-through securities, as many ABS are, which allows the flow through of income from the underlying assets to the investors without the trust itself being taxed.
- A revolving trust is used for assets with a high turnover, such as credit card, trade, and dealer-floor plan receivables. A revolving trust issues ABS with a revolving period, during which interest is paid to the investors, and an accumulation or controlled-amortization period, during which the principal is paid back as monthly payments over a specified time, usually 1 year.
- Another type of trust that offers more flexibility than a grantor trust is an owner trust, which is an amortizing trust used mostly with auto and student loans, and equipment leases.
The trust uses the services of an investment bank to underwrite the securities, much as a corporation would use an investment bank to underwrite the sale of bonds or stocks.
Taxes. Interest payments are taxed, but the return of principal is not. If the ABS was bought at a discount from the issuer, then taxes must be paid annually on the accrued interest; if bought in the secondary market, then taxes are due on a percentage of the principal and all interest income. (More: Taxation of Bond Income)
Most ABS issues are AAA rated, because they are secured by collateral or have credit enhancements. Asset-backed securities are diverse, with different yields, maturities, collateral, and credit ratings.
ABS can also be classified according to the type of payments made: amortizing and nonamortizing. Amortizing payments (aka liquidating loans) are used to pay off loans for a specific amount, whereas nonamortizing payments (aka revolving loans) are usually payments made on a revolving line of credit. Mortgages and auto loans are familiar examples of amortizing loans, whereas credit cards represent the most common type of revolving account. ABS based on amortizing payments pay both principal and interest to investors in each payment, whereas ABS based on revolving loans pay only interest for a specified amount of time, then pay only principal during the final phase before the final maturity date.
Because the cash flow of the underlying assets is uncertain, asset-backed securities are sold assuming an average maturity rather than giving a guaranteed maturity date.
Early amortization events (aka payout events, early calls) are events that will shorten the lifetime of the ABS, if there is any danger that the investors will not be fully paid. These payouts based on triggers are generally required by the credit rating agencies for an investment-grade rating.
Early amortization triggers include:
- insufficient payments by the underlying borrowers;
- insufficient excess spread;
- rise in default rate above a specified level;
- bankruptcy of sponsor or servicer.
Once triggered, the revolving, controlled-amortization, or accumulation period ends, and all money received from the underlying assets is used to return the principal to the ABS investors. The trigger and its sequel are irrevocable — everyone is paid regardless of the expected maturity date. Because income is received from the underlying assets monthly, payments to investors are monthly until everyone is paid in full.
Whereas the credit rating of bonds depends on the creditworthiness of the issuer, the credit rating of ABS is derived from the structure of the ABS rather by the issuer's ability to pay.
Because the credit rating of an ABS does not depend on the paying ability of a corporation, an ABS has less of a chance of a credit rating downgrade due to an event risk, such as can result from corporate buyouts, mergers, restructurings, and recapitalizations.
One of the major risks of asset-backed securities based on amortizing loans is prepayment and reinvestment risk. Prepayment risk results when the borrower pays off the loan sooner than expected. When interest rates decline, borrowers tend to pay off high interest loans with money borrowed at a lower interest rate, which shortens the average maturity of ABS. However, there is some prepayment risk even if interest rates rise, such as when an owner pays off a mortgage when the house is sold or an auto loan is paid off when the car is sold.
Since prepayment risk increases when interest rates decline, this also introduces reinvestment risk, which is the risk that the principal can only be reinvested at a lower rate. Prepayment and reinvestment risk prevents the increase in prices of amortizing ABS in the secondary market when interest rates fall, since there is a higher probability that the amortizing loans will be paid off early, with the concomitant retirement of the ABS. Indeed, these securities, unlike most bonds, will actually decline in price along with interest rates, thus exhibiting negative convexity.
ABS based on revolving accounts, such as credit cards, or on business receivables have less of a prepayment and reinvestment risk, since these accounts are used continually.
Secondary market prices for asset-backed securities have a variable sensitivity to interest rates. ABS based on amortizing loans, such as fixed-rate home-equity loans (HELs) based on 1st mortgages, are the most interest-rate sensitive, whereas ABS based on revolving accounts or business receivables are less so.
ABS are usually issued with minimum denominations of $1,000, sometimes higher. Despite the low denominations, most investors are institutional investors investing $1,000,000 or more. ABS dealers make markets in the over-the-counter (OTC) market, where there are fewer retail investors. Investment-grade ABS based on auto loans and credit cards are the most liquid ABS. Newer types of securities are much less liquid because of their novelty and limited distribution. Consequently, the bid/ask spread is greater for these securities.
Like bonds, some asset-backed securities pay either a fixed rate of interest or a floating rate (floaters). The actual yield earned by the investor will depend on the purchase price of the ABS and the actual term length of the security.
The interest rates on floaters are adjusted to a designated index, such as the LIBOR, or on Treasuries of comparable maturity. When the underlying portfolio consists of floating rate loans, such as credit card loans, then this provides a match between income and payments for the issuer. However, if the underlying portfolio pays a fixed rate of interest, this can still be converted to a floating rate ABS by the use of interest rate swaps, where the issuer swaps the fixed rate of the portfolio with a floating rate from a 3rd party, such as a bank.
The yields of asset-backed securities are generally higher than corporate bonds of comparable maturity and credit rating. The main reason for this is that the maturity is variable. Because cash flows resulting from loans and revolving lines of credit is highly variable, the maturity of an ABS is estimated by using prepayment models based on projections. If the projections are wrong, then the yield will be different than expected.
ABS also have a higher market risk in the secondary market, since the secondary market price will depend on the fluctuating credit spread between ABS and other types of fixed-income securities, and how many new issues of ABS are being brought to market. Factors specific to each type of ABS may also affect its price (sector risk), such as the recent subprime default rate on the price of mortgaged-backed securities, and other ABS based on home equity loans.
Servicers and Cleanup Call Provisions
Servicers manage the cash flow of almost all mortgage-backed securities as well as many other asset-backed securities, such as auto ABS. Servicers collect and process the payments from the loan pool and pay the investors. They also attempt to collect from delinquent borrowers. Servicers are paid a fixed fee that ranges from 0.5% to 2.0% of the pool's remaining collateral balance.
Hence, when the remaining pool balance falls below about 10% of the original balance, the cost to service the pool becomes greater than the servicing fee, so most asset-backed securities that depend on servicers are issued with a cleanup call provision, which gives the servicer the right, but not the obligation, to call all remaining bonds by paying the remaining balances. This, in effect, shortens the average life of the remaining bonds. Historically, the servicers of most ABS have exercised their cleanup call provision regardless of the prevailing interest rates.