Asset-backed securities

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Asset-backed securities (ABS) are financial securities backed by a loan, lease, or receivables [note 1] against assets other than real estate and mortgage-backed securities. [1] In the U.S., the ABS market had its start in 1985 when Sperry Lease Finance Corporation sold fixed-rate notes collateralized by computer leases. In 1986 GMAC issued notes backed by automobile loans. [2] Lehman Brothers (now Barclays Capital) introduced an index of asset-backed securities, the Barclays Capital U.S. Fixed-Rate Asset-Backed Securities Index in January 1992 when it was also added to the U.S. Aggregate Bond Index in its entirety.

Common assets securitized into asset-backed securities include:

  • Credit card receivables
  • Auto loans
  • Utility rate reduction bonds
  • Home equity loans
  • Student loans

Asset-backed securities are also used in the United Kingdom, Europe, Asia, and Emerging Markets.

Structure

Financial institutions, such as banks, credit card companies, auto finance companies, and finance companies sponsor asset backed securities by selling pools of loans to a separate special service vehicle (SPV) established for the sole purpose of securitizing the loans into marketable securities. The SPV sells the loans to a separate trust that actually securitizes the loans and then offers the asset-backed securities to investors. This process results in what is known as “bankruptcy remoteness,” since the “true sale” of the loans by the sponsor to the SPV insulates the trust from the credit risk of the sponsor. [3]

In order to attain investment grade status, rating agencies require that asset-backed securities provide credit enhancements to the securities. These enhancements take the shape of both internal and external enhancements. These enhancements are in addition to the SPV structural elements which strip the sponsoring institution of ownership rights in the loan pools (so that creditors of the sponsor have no rights to the loan assets). Internal enhancements include subordination, where the securities are issued in multiple tranches, [note 2] with senior securities (the first tranches) given protection from defaults: lower tranches absorb defaults before higher tranches. These senior tranches receive AAA ratings from rating agencies. Other internal enhancements include having higher collateral (the face value of loan portfolio is higher than the value of the security the collateral backs); and by retaining a yield spread (the security yield is less than the loan portfolio yield). The monthly excess spread is used to cover current-period losses and may be paid into a reserve fund to increase credit enhancement. A Reserve Fund is created to reimburse the trust for losses up to the amount of the reserve. It is often used in combination with other types of enhancement. [4]

External enhancements can include surety bonds, third party letters of credit, and cash collateral accounts. [4]

Amortization

The amortization [note 3] of an asset-backed security can take a number of forms, depending on the nature of the underlying loan or cash flows being securitized. Amortization can take the following forms: [5]

  • Fully Amortizing: Securities that return principal (such as auto loans, home equity loans, and manufactured housing contracts) to investors throughout the life of the security are designated fully amortizing securities. Depending on the underlying security, pre-payment risk may apply. [5]
  • Controlled Amortization: A method of providing investors with a relatively predictable repayment schedule, when the underlying assets (such as revolving credit card receivables) are nonamortizing. This method is similar to a sinking fund used in conjunction with a corporate bond issue.[note 4] Controlled amortization is subject to early-amortization risk. [5]
  • Soft/Hard Bullet: This structure is designed to return investor principal in a single payment. The most common "bullet" method is a soft bullet, which is not guaranteed (the principal payment period can be extended). A bullet structure has two cash flow periods: a revolving period (when any principal repayments are used to buy more receivables) and an accumulation period when principal payments are set aside in an escrow account to fund the bullet payment. The accumulation period is similar to a controlled amortization and is subject to early-amortization risk. [5]
  • Floaters: Some ABS debt issues (such as auto loans and credit card receivables) have a floating interest rate linked to an outside index such as LIBOR (London Interbank Offered Rate) or the prime rate. In instances where the underlying collateral is comprised of fixed-rate loans, the ABS trustee will use interest rate swaps with outside providers to reduce cash flow mismatches.[5]
  • Sequential Pay: For subordinated ABS debt issues, principal payment is sequential, with the first tranche (with the shortest average maturity) retired first, before later tranches.[5]

Returns and risks

The following table provides ABS index return data for the Barclays Capital U.S. Fixed-Rate Asset Backed Securities Index.

Table 1. Asset-backed securities Index returns [6]

Asset-backed securities are subject to the following major risks: [7]

  • Interest rate risk: Asset-backed securities will rise in price as interest rates decline, and fall in price as interest rates rise. Some asset-backed securities, namely those collateralized by home equity loans and manufactured housing loans, are subject to pre-payment risk, the risk that borrowers will refinance loans when interest rates fall, resulting in the early return of principal, which now must be reinvested at lower interest rates.
  • Early-Amortization risk: Bond principal payments can be accelerated if any number of triggering events occur. These events can include insufficient payments from underlying borrowers, deteriorating excess spreads, or increasing defaults. Accelerated payments are a requirement of the rating agencies. [note 5]
  • Default risk: The risk that an asset-backed security will default on the payment of interest and principal. According to S&P, defaults on investment quality asset backed securities have been very low. [note 6]

ABS indexes

Barclays Capital provides an index of asset-backed securities, the Barclays Capital U.S. Fixed-Rate Asset-Backed Securities Index. The index was introduced in January 1992 when it was also added to the U.S. Aggregate Bond Index in its entirety.

The U.S. Fixed-Rate Asset-Backed Securities (ABS) Index covers fixed-rate ABS with the following collateral types: credit cards, autos, and stranded-cost utility (rate reduction bonds). To be included in the index, an issue must have a fixed-rate coupon structure, have an average life greater than

or equal to one year, and be part of a public offering. [8]

Over time, the Barclays Capital U.S. Fixed-Rate ABS Index has added and removed a number of security classes from the index. For example, the index added manufactured housing securities to the index in 1999 and removed them from the index in 2008. Home equity loan securities were originally included in the index, but were excluded from the index starting in 2010.

Barclays Capital also provides an index for floating rate ABS securities, the Barclays Capital U.S. Floating Rate ABS Index. The index was introduced in May 2005 with history available from January 2005. This index is not included in the U.S Aggregate Index.

The U.S. Floating-Rate Asset-Backed Securities (ABS) Index covers floating-rate ABS with the following collateral types: home equity, credit card, auto (retail and wholesale loans), and student loans. To be included in the index, an issue must have a floating-rate coupon structure, have an average life greater than

or equal to one year, and be ERISA-eligible. [9]

Merrill Lynch also supplies an ABS index, the Merrill Lynch US ABS Index.

Barclays supplies the following indexes for non-U.S asset-backed securities. As in the U.S., the fixed rate ABS indexes are included in the Barclay global and international aggregate indexes. The floating rate ABS indexes are not included in aggregate indexes. Euro and Sterling indexes were introduced in January 2004. The Pan-European indexes were introduced on March 25, 2010. [10]

  • Pan-European ABS Fixed Rate Index
  • Pan-European ABS Floating Rate Index
  • Euro ABS Fixed Rate Index
  • Euro ABS Floating Rate Index
  • Sterling ABS Fixed Rate Index
  • Sterling ABS Floating Rate Index

Notes

  1. An amount due from individuals and companies. Receivables are claims that are expected to be collected in cash. From Wikipedia.
  2. Tranches: A piece, portion or slice of a deal or structured financing. This portion is one of several related securities that are offered at the same time but have different risks, rewards and/or maturities. "Tranche" is the French word for "slice". From investopedia
  3. Amortization: the paying off of debt in regular installments over a period of time. From investopedia
  4. Sinking fund: A means of repaying funds that were borrowed through a bond issue. The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. From investopedia
  5. Investopedia defines Early Amortization:
    A type of credit enhancement used in certain asset backed securities (ABS). Early amortization is an accelerated payment of bond principal in an asset-backed security, usually triggered when there is a sudden increase in delinquencies in the underlying loans or when excess spread, the issuer's net profit after deducting servicing fees, charge-offs and other costs, falls below an acceptable level. Also called a payout event.

    Early amortization signals liquidity crisis for the originator, as funding dries up. The early payout protects investors from prolonged exposure to receivables with deteriorated credit performance. However, the investor is relying on the fixed income from the ABS - prepayment is an inherent risk for investors.

  6. The S&P study, U.S. Asset-Backed Securities Have Maintained High Credit Stability And Low Default Rates Since 1983, (May,2011) is unavailable. However, an S&P sponsored video concerning the study, and the study abstract are available:
    Abstract: Although housing-related sectors suffered during the recent economic downturn, ratings on U.S. asset-backed securities (ABS) have generally remained stable. More specifically, 94.3% of 'AAA' rated U.S. ABS maintained their ratings or were paid off in full during the 12 months ended April 30, 2011. In other words, Standard&Poor's Ratings Services lowered its ratings on only 5.7% of the 'AAA' rated securities, and none defaulted. (Watch the related CreditMatters TV segment titled, "U.S. ABS: High Credit Stability And Low Default Rates," dated June 17, 2011.) Looking back further, from 1983 through April 2011, 93% of U.S. ABS originally rated 'AAA' remained stable or were paid in full, and 0.10% defaulted. We lowered our ratings on 7.0% of these securities. Video link: SP: U.S. ABS: High Credit Stability And Low Default Rates.

References

  1. definition, investopedia
  2. Asset-backed securities The Concise Encyclopedia of Economics
  3. Asset-backed securities SIMFA, investinginbonds.com.
  4. 4.0 4.1 Credit enhancement SIMFA, investinginbonds.com.
  5. 5.0 5.1 5.2 5.3 5.4 5.5 How Are ABS Structured SIMFA, investinginbonds.com.
  6. Dreyfus Periodic Table 2001-2010
  7. Market risks SIMFA, investinginbonds.com.
  8. Factsheet available from Barclays Capital Guides
  9. Factsheet available from Barclays Capital Guides
  10. Barclays Capital press release

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