In finance, an asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the
cash flows from a specified pool of underlying assets. Assets are pooled to make otherwise minor and uneconomical investments
worthwhile, while also reducing risk by diversifying the underlying assets. Securitization makes these assets available for investment to a broader set of investors. These asset
pools can be made of any type of receivable from the common, like credit card payments, auto loans, and mortgages, or esoteric
cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitised assets might be highly
illiquid and private in nature.
In some cases it can be used as credit enhancement by creating a security that has
a higher rating than the issuing company which monetizes its assets. This allows it to pay a lower rate of interest than would be
possible via a secured bank loan or debt issuance.
Structure
On January 18, 2005, the SEC promulgated Regulation
AB which included a final definition of Asset-Backed Securities. [1]
- "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 staff has historically interpreted the phrase "convert into cash by
their terms" to exclude from the definition most assets that require positive action to be realized upon – such as non-performing
assets and physical property. It has also interpreted the "discrete pool" requirement in such a way as to disqualify most
securities issued in transactions where the composition of the pool is not set on the date of issuance or can change over time.
The new rules modify these existing interpretations in certain respects while codifying them in others.
-
- Lease-Backed Securities. The new rule expands the definition of "asset-backed security" to include lease-backed securities as
long as the residual value of the leased property is less than 50% of the original securitized pool balance (or less than 65% in
the case of motor vehicle leases). However, such securities may be shelf-registered on Form S-3 only if the residual value of the
leased property represents less than 20% of the original securitized pool balance (or less than 65% in the case of motor vehicle
leases).
-
- Delinquent and Non-performing Assets. The new rules provide that a security may be considered to be an "asset-backed
security" even if the underlying asset pool has total delinquencies of up to 50% at the time of the proposed offering as long as
the original asset pool does not include any "non-performing" assets. However, consistent with current practice, shelf
registration on Form S-3 will be available only if delinquent assets constitute 20% or less of the original asset pool. An asset
is considered to be non-performing if it satisfies the charge-off policies of the sponsor (or applicable bank regulatory
agencies) or if it would be considered a charged-off asset under the terms of the applicable transaction documents.
-
- Exceptions to the "Discrete Pool" Requirement. The new rules generally codify the SEC staff’s position that a security must
be backed by a discrete pool of assets in order to be considered an ABS. However, the new rules establish the following
exceptions to address market practices.
-
- (1) Any security issued in a master trust structure would meet the definition of "asset-backed security" without
limitation.
-
- (2) "asset-backed securities" will also include securities with a prefunding period of up to one year during which up to 50%
of the offering proceeds (or, in the case of master trusts, up to 50% of the aggregate principal balance of the total asset pool
whose cash flows support the ABS) may be used for subsequent purchases of pool assets.
-
- (3) The new rules also include within the definition of "asset-backed security" securities with revolving periods during
which new financial assets may be acquired. In the case of revolving assets such as credit cards, dealer floorplan and home
equity lines of credit, there is no limit to the length of the revolving period or the amount of new assets that can be purchased
during that time. For securities backed by receivables or other financial assets that do not arise under revolving accounts, such
as automobile loans and mortgage loans, an unlimited revolving period will be permitted for up to three years. However, the new
assets added to the pool during the revolving period must be of the same general character as the original pool assets.
According to Thomson Financial League Tables, US issuance (excluding
mortgage-backed securities) was:
- 2004: USD 857 billion (1,595 issues)
- 2003: USD 581 billion (1,175 issues)
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 HEL 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.
[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:
- Prime auto ABS are collaterlized by loans made to borrowers with strong credit histories.
- Nonprime auto ABS consist of loans made to lesser credit quality consumers, which may have higher cumulative losses.
- Subprime borrowers will typically have lower incomes, tainted credited histories, or both.
Owner trusts are the most common structure used when issuing auto loans and allow investors to receive interest and principal
on sequential basis. Deals can also be structured to pay on a pro-rata or combination of the two. [2]
Credit card receivables
Securities backed by credit card receivables have been benchmark for the ABS market since they were first introduced in 1987.
Credit card holders may borrow funds on a revolving basis up to an assigned credit limit. The borrowers then pay principal and
interest as desired, along with the required minimum monthly payments. Because principal repayment is not scheduled, credit card
debt does not have an actual maturity date and is considered a nonamortizing loan.[2]
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 of which the most common is the de-linked master trust. Discrete trusts consist of a fixed or static pool
of receivables that are tranched into senior/subordinated bonds. A master trust has the
advantage of offering multiple deals out of the same trust as the number of receivables grows, each of which is entitled to a
pro-rata share of all of the receivables. The delinked structures allow the issuer to separate the senior and subordinate series
within a trust and issue them at different points in time. The latter two structures allow investors to benefit from a larger
pool of loans made over time rather than one static pool.[2]
Student loans
ABS collateralized by student loans (“SLABS”) comprise one of the four (along with home
equity loans, auto loans and credit card receivables) core asset classes financed through asset-backed securitizations and are a
benchmark subsector for most floating rate indices. 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 ("DOE") at rates ranging from 95%-98% (if the student loan is serviced by a servicer designated as an "exceptional
performer" by the DOE the reimbursement rate was up to 100%). As a result, performance (other than high cohort default rates in
the late 1980's) has historically been very good and investors rate of return has been excellent. Recent legislation passed on
September 7, 2007 by the House of Representatives and U.S. Senate decreases lender special allowance payments, eliminates the
exceptional performer designation, increases lender insurance rates and the lender paid origination fee for specific loans.
A second, and faster growing, portion of the student loan market consists of non-FFELP or private student loans. Though
borrowing limits on certain types of FFELP loans were slightly increased by the student loan bill referenced above, essentially
static borrowing limits for FFELP loans and increasing tuition are driving students to search for alternative lenders. Students
utlilize private loans to bridge the gap between amounts that can be borrowed through federal programs and the remaining costs of
education.
[2]
Stranded cost utilities
Rate reduction bonds (RRBs) came about as the result of a 1992 National Energy Policy, which was designed to increase
competition in the electricity market. To avoid any disruptions while moving from a non-competitive to a competitive market place
regulators have allowed utilities to recover certain "transition costs" over a period of time. These costs are considered
nonbypassable and are added to all customer bills. Since consumers usually pay utility bills before any other, chargeoffs have
historically been low. RRBs offerings are typically large enough to create reasonable liquidity in the aftermarket, and average
life extension is limited by a "true up" mechanism.[2]
Others
There are many other cash-flow-producing assets, including manufactured housing loans, equipment leases and loans, aircraft
leases, trade receivables, dealer floor plan loans, and royalties. [2]
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." [3]
"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." [3]
"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." [3]
"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."[3]
The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap rate. For example, the price of
a credit card-backed, AAA rated security with a two-year maturity by a benchmark issuer might be quoted at 5 basis points (or
less) to the two-year swap rate." [3]
"Indeed, market participants sometimes view the highest-rated credit card and automobile securities as having default risk
close to that of the highest-rated mortgage-backed securities, which are reportedly viewed as substitute for the default
risk-free Treasury securities."[3]
Securitization
-
- See also: Credit enhancement
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
- See also: asset-backed securities
index
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.[4] ABS indices allow investors to gain broad exposure to the subprime market without holding the actual
asset-backed securities.
Advantages
A significant advantage of asset-backed securities 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. Their bankruptcy remoteness allows the investor to
take on credit risk of the asset without taking on specific corporate credit risk of the originator. The tranching of these
securities into instruments with different risk/return profiles facilitates marketing of the bonds to investors with different
risk appetites and investing time horizons.
Asset-backed securities enable the originators of the loans to enjoy most of the benefits of lending money without bearing the
risks involved. They offer originators the following advantages:
- Selling these financial assets to the pools reduces their risk-weighted assets and thereby frees up their capital, enabling
them to originate still more loans.
- Asset-backed securities lowers their risk. In a worst-case scenario where the pool of assets performs very badly, the owner
of ABS would pay the price of bankruptcy rather than the originator.
- The originators earn fees from originating the loans, as well as from servicing the assets throughout their life.
"The financial institutions that originate the loans sell a pool of cashflow-producing assets to a specially created third
party that is called a special-purpose vehicle (SPV). The SPV is designed to insulate investors from the credit risk of the
originating financial institution. The SPV then sells the pooled loans to a trust, which issues interest bearing securities that
can achieve a credit rating separate from the financial institution that originates the loan. The typically higher credit rating
is given because the securities that are used to fund the securitization rely solely on the cash flow created by the assets, not
on the payment promise of the issuer. The monthly payments from the underlying assets—loans or receivables—typically consist of
principal and interest, with principal being scheduled or unscheduled. The cash flows produced by the underlying assets can be
allocated to investors in different ways. Cash flows can be directly passed through to investors after administrative fees are
subtracted, thus creating a “pass-through” security; alternatively, cash flows can be carved up according to specified rules and
market demand, thus creating "structured" securities." [5]
See also
References
- ^ "Financial Services Alert" Goodwin and Procter, January
18th 2005, Vol. 8 NO. 22
- ^ a b c d e f g Fixed Income
Sectors: Asset-Backed Securities A primer on asset-backed securities, Dwight Asset management Company 2005
- ^ a b c d e f T Sabarwal "Common Structures of Asset-Backed Securities and Their Risks,
December 29, 2005
- ^ https://www.markit.com/marketing/press_releases.php?date=17Jan2006
- ^ "Fixed Income Sectors: Asset-Backed Securities", Dwight Asset
Management Company, 2005.
External links
- Leading Investment Bankers in the Asset-Backed Securities Market, according to Asset-Backed
Alert
Further reading
- Jason H. P. Kravitt, Securitization of Financial Assets, Second Edition, Aspen Publishers, New York, New York,
2005.
- Steven L. Schwarcz, Structured Finance A Guide to the Fundamentals of Asset Securitization, November 1990, Second
Printing, Practicing Law Institute.
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