What are Asset-Backed Securities (ABS)?
An asset-backed security is an investment vehicle secured by a pool of underlying assets. The underlying asset pool or underlying loans are generally home equity loans, auto loans, credit card debt, private student loans, residential & commercial mortgages, collateralised debt obligations, and the like. All kinds of asset-backed securities are financial derivatives since their values are derived from the underlying assets.
Asset backed securities are sold in bonds or notes and guarantee a fixed income till maturity. Unlike corporate bonds and stocks, the issuer’s ability to pay the investor depends substantially on shrewd managerial skills and is not subject to external risks beyond their control. The existence of collateral before the securitisation of the asset pool makes asset-backed securities (ABS) ensure that the onus of investor payments does not lie upon the originator but solely on the quality & credibility of the underlying assets.
The asset pools of these fixed-income instruments can be varied and generally include home equity loans, automobile loans, credit card receivables, real estate loans, mortgage loans, and other types of bank loans. Similar classes of loans are pooled and packaged together to be repurposed & sold as securitised assets. The benefits for the issuer are twofold – the associated risk is off balance sheet, and investor money flows in.
What is Asset Backing?
The definition of asset backing differs concerning the context of its use.
Asset backing is an evaluation method for determining a business’s real internal or intrinsic value. In business, asset backing refers to the valuation of a company’s shares based on the assets it holds. Asset backing is calculated by determining the total valuation of all company assets and dividing it by the total number of company shares.
Regarding investments, asset backing is the process by which tradable securities are backed by a single or pool of underlying assets. These pools’ principal and interest payments are channelled to investors/buyers of securities.
How Does Asset Securitisation Work?
Any major public or private commercial bank that offers different kinds of loans, including MSME loans, auto loans, education loans, mortgage loans, personal loans, credit card receivables, and the like. Now, numerous different kinds of loans have been availed throughout the year. Different loans such as home equity, auto, mortgage, education, and other bank loans have been taken out, with all borrowers agreeing to make routine EMI payments until the loan matures. Each loan is an asset for the bank, as they promise a steady cash flow.
Now different loans will carry with them different types of risks. Credit, prepayment, and inflation risks are common risks that almost all loan types suffer from. And in a bid to mitigate those risks, lenders pool together homogeneous loan types and sell them to special purpose vehicles (SPVs) or investment firms.
The special purpose vehicle or investment bank re-packages these asset pools into tranches of similar loans & offers them up for sale in capital markets as interest-bearing securities. ABS investors buy these securities to assure periodic interest payments, and the money they invest makes its way to the loan originators, the financial institutions that handed out the loan. The cash flows from the underlying assets or bank loans stem from the borrower’s debt obligations, who pay EMI at pre-determined interest rates.
Loans are considered assets in the banking sector due to the cash flows they generate, albeit with certain risks. Pooling, re-packaging, and selling these risky assets to an investment bank or SPV negates the risks as they go off balance sheets. The investment firm turns them into tradable securities backed by the cash flow generated from the underlying assets.
This is the basic idea behind asset backed securities (ABS) or securitised assets, as well as collateralised debt obligations and mortgage backed securities. Collateralised bond obligations are investment-grade bonds that pool together multiple junk bonds and reduce the risks associated with those low-grade junk bonds.
Asset-backed securities, collateralised debt obligations, and mortgage-backed securities are generally classified according to their delinquency risks, maturity period, interest rate, etc., and rating agencies accordingly. These classifications are known as tranches. Any asset-backed security is generally classified into the following three tranches: Class A, Class B, and Class C. Class A tranches are usually the largest of all tranches and most attractive. Class B and Class C tranches have consecutively lower credit ratings.
What are examples of Asset-Backed Security?
There are different kinds of asset-backed securities in the market by financial institutions. Various underlying assets or loans possess different characteristics and pose different types of credit risk. Some are secured & some unsecured; some are for buying homes & automobiles, while some are for higher studies, maintaining working capital, buying equipment, expanding operations and the like.
Credit card debt and auto loans may form the underlying assets for one asset-backed securities class. In contrast, mortgage-backed securities ( both residential mortgage-backed securities and commercial mortgage-backed securities) have commercial real estate loans, mortgage loans, commercial mortgages and residential mortgages as underlying assets pools. Securitised assets such as collateralised or collateralised debt obligations can have any kind of secured loan, personal or corporate debt as underlying assets.
Simply put, the portfolio of different asset-backed securities can be quite diverse. The underlying collateral of the underlying assets of debt obligations adds a layer of security against any credit risk.
Besides debt, other illiquid assets and even tradable financial instruments can be underlying assets of such securities. Collateralised bond obligations are one such example. Even asset-backed securities can be securitised further and turned into ABS Squared! Simply put, any financial instrument that produces a steady & reliable cash flow can be turned into securitised assets.
Types of Asset-Backed Securities
1. Collateralised Debt Obligation (CDO)
A collateralised debt obligation is a common type of asset backed security. They are generally issued by special purpose vehicles of financial institutions. They are intricate structured financial products, which are backed by pools of collateralised loan pools. Originators generally sell collateralised debt obligations to institutional investors who market them as different tranches of interest-bearing tradable securities. These tranched securities become the final marketable product. The cash flows generated from the principal or monthly mortgage payments are passed on to the buyer of securities, and the associated collateral becomes the asset in case of default.
Collateralised debt obligations have different sub-types, namely:
- Collateralised loan obligations, which have different kinds of bank loans as underlying assets
- Collateralised bond obligations, which have multiple junk bonds as the asset pool
- Collateralised mortgage obligations have mortgage loans, residential mortgages, and commercial mortgages as underlying assets, and their monthly payments act as cash flows for the security. Mortgage backed securities were the reason behind the 2007 financial crisis.
Though collateralised debt obligations are considered a subset of asset backed securities (ABS), they are much broader in scope and include different kinds of assets. They may include any cash flow generating asset, from mortgages to student loans & credit card debt. CDOs are separated into tranches according to the risks associated with their underlying assets.
Issuers can create a new CDO by pooling and re-packaging risky mortgage loans or the junk-rated tranches of other CDOs. Compiling them together, a new senior tranche of CDO may be created with significantly higher credit ratings than its predecessors or the assets backing it.
2. Home Equity ABS
Asset backed securities based on home equity loans are some of the most common in the Indian market. Like mortgage-backed security, borrowers generally take out home equity loans with less than stellar credit ratings. There are three types of payments associated with home equity ABS- principal payments, interest payments, and prepayments.
3. Auto Loan ABS
As evident from the name, Auto Loan asset backed securities have auto loans as their underlying assets. Cash flows generated from a typical auto loan stem from principal payments, interest payments, and prepayment.
4. Credit Card Receivables ABS
Credit card receivables and credit card debt are the underlying assets in this case. These securitised assets do not have to provide any fixed income, and new loans or assets are added to the underlying pool of a credit card receivables asset backed security.
Th due amount in one’s credit card balance is the primary underlying asset in the underlying pool. As they are a revolving line of credit, new loans must be added to the pool for continual payments to investors. Credit card receivables ABS have a certain lockup period during which no payments are made.
5. Student Loan ABS
Pools of student loans make up the underlying loan pool of student loan ABS. Both government-backed and private loans are pooled & re-packaged. Student loan asset backed securities have outstanding student loans as underlying assets.
Like every other type of ABS, one of the primary purposes of student loan ABS is to spread and diversify the credit risk among investors. Doing so allows lenders to hand out more student loans of diverse amounts, thanks to all the money investors put in. Investors get a routine payout, similar to coupon payments from government bonds.
Lenders take credit risks off balance sheet, more & more students can avail of student loans, and investors get to diversify their investment portfolio thanks to student loan ABS.
Mortgage-backed securities are another major type of asset-backed security with mortgage loans as underlying assets. Risky loans on residential and commercial mortgages are laid off balance sheet by a financial institution and sold to investment firms or SPVs who trade them in the ABS market. Commercial mortgage backed securities, and residential mortgage backed securities are two prominent MBS types.
MBS are divided into class A (tranche with the lowest risk), class B (mezzanine tranche of mid risk), and class C (unsecured tranche with the highest risks) and then sold accordingly to secondary market participants.
Another key thing to note is that almost all bank loans carry a prepayment risk, which is transferred to the ABS market participants.
Benefits of Asset-Backed Securities
1 Protects from potentially risky loans
Asset-backed securities allow banks to put risky loans off balance sheet. Securitising risky assets through SPVs or institutional investors help banks shave off the risks and share them with both the issuer & the investor. Said securitisation also helps banks gain quick funds from investors and can use the amount to offer more secured & unsecured loans.
2 Provides an alternative and more stable investment vehicle
From the investor’s point of view, asset-backed securities are a great way to diversify their investment portfolio. Class A asset-backed securities are highly secure and generally have collateral backing up the underlying assets. At the same time, asset-backed securities act as the bridge between the investor’s wealth and the borrower’s debt, allowing investors to lend indirectly to the public.
3 Reduces default risk and other credit risks
Asset-backed securities (ABS) are fixed-income instruments for investors, enabling them to receive periodic payments without getting involved in any debt obligations. Underlying assets of asset-backed securities have pools of multiple loans, which help in mitigating any credit or default risk. One can get their hands on principal payments and payments at a certain interest rate without worrying about originating any loan.