, an asset-backed security
is a type of debt security
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, to esoteric cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitized 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.
On January 18, 2005, the United States Securities and Exchange Commission (SEC
) promulgated Regulation AB which included a final definition of Asset-Back Securities.
- "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)
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 HE 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.
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.
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.
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.
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.
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. 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.
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.
Stranded cost utilities
Rate reduction bonds (RRBs) 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 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.
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. 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 (or less) 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."
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.
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. ABS indices allow investors to gain broad exposure to the subprime market without holding the actual asset-backed securities.
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."
- Leading Investment Bankers in the Asset-Backed Securities Market, according to Asset-Backed Alert
- 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.
- McLean, Bethany (2007). "Asset Backed Securities: The Dangers of Investing in Subprime Debt", Fortune