Asset-backed securities

Asset-backed securities (ABSs) are structured finance products backed by pools of assets and are created through a securitisation process. The risks in asset-backed securities, such as credit risk, prepayment risk, market risks, operational risk, and legal risks, are directly connected with the asset pool and the structuring of the securities.

Securitisation is a financial process by which an owner of an asset, such as a portfolio of loans, receives cash upfront in exchange for the future cash flows from the asset without selling the asset in a normal contractual sales agreement. This process entails pooling the cash flows and selling them to investors via a special purpose vehicle (SPV), effectively turning ‘illiquid’ assets that cannot be sold easily into a ‘liquid’ asset that is tradable. If the income is ‘backed’ by underlying assets the securities are called ‘asset-backed securities’.

There are two main reasons for carrying out a securitisation: Asset-backed securities

  1. to obtain funding, because selling the cash flows allows the seller to bring forward the future income of the assets and use it for immediate reinvestment; and
  2. to move assets off the balance sheet.

In principle, any asset with associated cash flows can be securitised, for example, mortgages or loans such as credit cards, commercial loans and student loans. Depending on the underlying asset, the securities carry different names as shown below.

Types of securities

Security name Description
A residential mortgage-backed security (RMBS) Backed by mortgages for the purchase of a residential real estate. Includes ‘prime’ mortgages, where borrowers have strong credit histories, ‘buy to let’ mortgages, or ‘non-conforming’ mortgages.
A commercial mortgage-backed security (CMBS) Backed by mortgages for the purchase of a commercial property.
Consumer asset-backed security (Consumer ABS) Backed by personal financial assets such as auto loans, credit cards, student loans, and other consumer loans.
A corporate asset-backed security (Corporate ABS) Backed by the cash flows from receivables such as leases on aircraft or other corporate equipment, small and medium enterprise (SME) loans, trade receivables. Also includes ‘whole business’ securities (WBS) based on the cash flows of an entire business unit, such as franchise or brand royalties.
Collateralised debt obligation (CDO) Backed by a mixture of loans/receivables and/or asset-backed securities. Also includes ‘collateralised loan obligations’ (CLO) backed by loans, often to medium-sized corporates.

Example

Let’s assume Company XYZ is in the business of making auto loans. When it makes a loan, it gives cash to the borrower and the borrower agrees to repay that amount with interest.

But if Company XYZ wants to make more loans, it may find itself needing cash to do so. This is where asset-backed securities come in.

Company XYZ can sell its auto loans to ABC Investments. As a result, Company XYZ receives cash to make more loans, and it transfers those auto loans from its balance sheet to ABC’s balance sheet.

ABC Investments may group these auto loans into tranches–groups of loans that may have common characteristics such as maturity or delinquency risk. ABC then issues a security similar to a bond that essentially keeps an administrative fee for itself and then “forwards” the remaining proceeds from the auto loans to the investors.

The asset-backed securities trade on various exchanges, similar to any other security. Public ABS offerings must satisfy stock exchange requirements (for example the Irish Stock Exchange) including providing regular financial disclosures to investors. Ratings agencies may assign a rating to the securities based largely on the probability that the underlying expected cash flows will materialize. In some cases, the asset-backed securities will receive higher credit ratings than the issuer has for itself; this is a reflection of the risk associated with the certainty of the asset-backed securities’ underlying cash flows.

Asset-backed securities

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