Asset-Backed Securities (ABS)

Regardless if the assets are loans, or mortgages, the steps in creating an ABS is similar:

1. Collateralization: loans are established, each of which has an asset associated with it that provides some reassurance against default on the loan. For example, in the event an automobile loan goes into default, the car can be repossessed and sold.

2. Special Purpose Vehicle: a bankruptcy remote trust is created, which removes the bankruptcy risk associated with the investment bank creating the trust. The special purpose vehicle, or SPV, will essentially be the institution selling the securities to investors.

3. Securitization: this is the actual pooling of assets such as mortgages, car loans, student loans and credit card debt into a security, or securities, to be sold to investors. The SPV provides the service of securitizing the assets.

To summarize, the above process might go something like this: Lenders reach a point where they need to clean up their balance sheets so they can write additional loans. They sell their collateralized loans to a large financial institution, which creates a special purpose vehicle, or trust, and these loans are placed into that trust. Cash flows into this trust as payments on the loans are made, and cash flows out as payments are made to the investors that purchased the securities issued by the trust.

When the special purpose vehicle is created by a financial institution, it is sometimes referred to as a bankruptcy remote trust. Depending on the quality of the assets, the SPV can have a higher (better) overall credit rating than the financial institution that created it. Furthermore, the trust will typically subdivide the pool of securities into what are called tranches. Each tranche carries a different combination of risk and reward and might include:

• Senior Debt: takes priority over all other tranches issued.

• Mezzanine Debt: next in line for payment; it's subordinate only to the senior debt.

• Junior Debt: paid after both the senior and mezzanine debt.

• Equity: there can also be an equity tranche, and dividends can be paid to holders of the equity tranche once all other debt holders have been paid.

The trading of asset-backed securities takes place on various exchanges, and is similar to the process of trading corporate bonds. Public offerings need to satisfy the U.S. Securities and Exchange Commission requirements. This will include financial disclosures to investors. These securities are often assigned ratings from credit agencies based on the quality of the underlying cash flow. Interest payments can be passed directly through to investors after administrative fees are subtracted. This arrangement is referred to as a "pass-through" security. With "structured" securities, payments to investors are distributed according to predetermined rules.

The most common types of collateral used for asset-backed securities appear below:

• Home Equity Loans: the largest class of ABS, a Home Equity Loan (HEL) allows homeowners to borrow money using the equity they have in their homes as collateral. This class of asset-backed securities can also include revolving credit, as is the case with Home Equity Lines of Credit (HELOC).

• Automobile Loans: the second largest class of ABS, the collateral used by borrowers in this situation is a car.

• Credit Card Receivables: with credit card receivables, the card issuing company will sell securities through a master trust. These securities are backed by a loan portfolio, not by specific receivables since credit card balances are in a constant state of flux.

• Student Loans: also referred to as SLABS, these are typically Federal Family Education Loan Program (FFELP) loans, which are guaranteed by the U.S. Department of Education.

• Leases: also referred to as lease-backed securities, this can include both open and closed end leases on automobiles, aircraft, personal computers, copiers, and similar types of business equipment.

Collateralized Bond Obligations, or CBOs, are another type of asset-backed security. These investments warrant an entirely separate topic, and have been covered in our article: collateralized bond obligations.

Asset-backed securities provide lenders with the ability to trade a collection of assets that could not be sold individually. Turning these illiquid assets into cash, lenders are then free to write additional loans. By creating tranches of securities from this pool of assets, investors are able to select a risk / reward offering that aligns with their risk tolerance. Finally, asset-backed securities pay investors a yield premium when compared to more traditional offerings carrying the same credit ratings. While all securities carry certain risks, such as interest rate and market liquidity, there are three significant risks investors assume when they purchase ABS:

• Prepayment: borrowers can choose to prepay, or accelerate their payments such that their loan is paid off ahead of schedule. For example, a homeowner might add $100 to their monthly mortgage payment to reduce the outstanding principal on the loan.

• Repayment: if interest rates are falling, borrowers may decide to refinance their loans at more attractive rates.

• Non-payment: when borrowers can no longer afford to repay money owed on their loans, cash may not flow into the trust as expected, or the entire balance of the loan may be lost to bankruptcy.

All of the above result in the unscheduled shrinking of the assets held in the trust, or the premature return of a portion of the investor's money. In the case of bankruptcy, not only is the cash flow into the trust lost, but the eventual repayment of the investors' money is uncertain.