Asset-backed security
An asset-backed security is a security whose income payments, and hence value, are derived from and collateralized by a specified pool of underlying assets.
The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can vary from common payments on credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments, or movie revenues.
Often a separate institution, called a special-purpose vehicle, is created to handle the securitization of asset-backed securities. The special-purpose vehicle, which creates and sells the securities, uses the proceeds of the sale to pay back the bank that created, or originated, the underlying assets.
The special-purpose vehicle is responsible for "bundling" the underlying assets into a specified pool that will fit the risk preferences and other needs of investors who might want to buy the securities, for managing credit risk – often by transferring it to an insurance company after paying a premium – and for distributing payments from the securities. As long as the credit risk of the underlying assets is transferred to another institution, the originating bank removes the value of the underlying assets from its balance sheet and receives cash in return as the asset-backed securities are sold, a transaction which can improve its credit rating and reduce the amount of capital that it needs. In this case, a credit rating of the asset-backed securities would be based only on the assets and liabilities of the special-purpose vehicle, and this rating could be higher than if the originating bank issued the securities because the risk of the asset-backed securities would no longer be associated with other risks that the originating bank might bear. A higher credit rating could allow the special-purpose vehicle and, by extension, the originating institution to pay a lower interest rate on the asset-backed securities than if the originating institution borrowed funds or issued bonds.
Thus, one incentive for banks to create securitized assets is to remove risky assets from their balance sheet by having another institution assume the credit risk, so that they receive cash in return. This allows banks to invest more of their capital in new loans or other assets and possibly have a lower capital requirement.
Definition
An "asset-backed security" is sometimes used as an umbrella term for a type of security backed by a pool of assets, and sometimes for a particular type of that security – one backed by consumer loans or loans, leases or receivables other than real estate. In the first case, collateralized debt obligations and mortgage-backed securities, are subsets, different kinds of asset-backed securities.. In the second case, an "asset-backed security" – or at least the abbreviation "ABS" – refers to just one of the subsets, one backed by consumer-backed products, and is distinct from a MBS or CDO, (example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO.... Securitization issues backed by consumer-backed products – car loans, consumer loans and credit cards, among others – are called ''ABS''Structure
United States
On January 18, 2005, the United States Securities and Exchange Commission promulgated Regulation AB which included a final definition of Asset-Backed Securities.According to Thomson Financial League Tables, US issuance was:
- 2004: USD 857 billion
- 2003: USD 581 billion
Types
Home equity loans
Securities collateralized by home equity loans 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 HE loans can consist of high loan to value loans, re-performing loans, scratch and dent loans, or open-ended home equity lines of credit, which homeowners use as a method to consolidate debt.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 collaterized 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.
Credit card receivables
Securities backed by credit card receivables have been benchmark for the ABS market since they were first introduced in 1987. A credit card holder may borrow funds on a revolving basis up to an assigned credit limit. The borrower then pays 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.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.
Student loans
ABS collateralized by student loans comprise one of the four core asset classes financed through asset-backed securitizations and are a benchmark subsector for most floating rate indices. Federal Family Education Loan Program loans are the most common form of student loans and are guaranteed by the U.S. Department of Education at rates ranging from 95%–98%. As a result, performance has historically been very good, and investors' rate of return has been excellent. The College Cost Reduction and Access Act became effective on October 1, 2007, and significantly changed the economics for FFELP loans; lender special allowance payments were reduced, the exceptional performer designation was revoked, lender insurance rates were reduced, and the lender paid origination fees were doubled. The FFELP loan program ended in 2010, but as of 2020 there was about $245 billion in outstanding debt from 11 million debtors.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 utilize private loans to bridge the gap between amounts that can be borrowed through federal programs and the remaining costs of education.
The United States Congress created the Student Loan Marketing Association as a government-sponsored enterprise to purchase student loans in the secondary market and to securitize pools of student loans. Since its first issuance in 1995, Sallie Mae is now the major issuer of SLABS and its issues are viewed as the benchmark issues.
Stranded cost utilities
Rate reduction bonds came about as the result of the Energy Policy Act of 1992, which was designed to increase competition in the US electricity market. To avoid any disruptions while moving from a non-competitive to a competitive market, regulators have allowed utilities to recover certain "transition costs" over a period of time. These costs are considered non-bypassable 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.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, securities portfolios, and royalties. Intangibles are another emerging asset class.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.""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."
"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."
"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."
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 to the two-year swap rate."
"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."