Asset-backed security

A debt security using specific assets that have predictable and similar cash flows. Asset-backed securities have been at the core of the 2008 financial meltdown.

ABS consist of financial assets that otherwise could not easily be traded in their existing form. These illiquid assets are pooled together into a large portfolio and converted into instruments that are then offered and sold freely in the capital markets.

Generally speaking, any asset generating a revenue stream can be repackaged as a marketable debt security. The majority of Asset-backed securities use loans and other financial assets as collateral. The largest segment of the ABS market includes home-equity loans, auto loans, credit cards and student loans.

There are a number of ways to classify securitized assets, but the defining factor may be whether or not they are amortized or non-amortized. An amortized loan is paid off over a defined period with regular payments of both principal and interest, such as home-equity loans.

A non-amortized loan, sometimes referred to as a revolving loan, doesn’t require scheduled principal payments, but does require that the interest be paid on time. The best example of non-amortized loans is revolving credit card accounts.

While the term asset-backed securities has recently been associated with long-term collateral such as home mortgages, or mortgage-backed securities—those securities largely thought to be the main culprit in the recent financial crisis—ABS can also refer to short-term collateral such as credit-card receivables and other categories listed below.

Types of Assets That Back Debt Securities

Home-Equity Loans
These loans represent the largest sector of the ABS market. Home-equity loans, once known as “second mortgages,” were once considered the borrowing of last resort. Today, thanks to clever and ubiquitous ad campaigns, these loans have undergone an image transformation and have not become universally accepted.

Since the early 1980s, the amount of outstanding home equity loans has ballooned to more than $1 trillion from $1 billion, and nearly a quarter of Americans with first mortgages also have home-equity loans.

Auto Loans
The second largest, and the oldest, asset class in the ABS market is auto loans. These securities, which form a large and liquid part of the ABS market, are based on the cash flow of customer payments from a particular pool of auto loans or leases. Unlike mortgage-backed securities, auto ABS are relatively unaffected by prevailing interest rates.

Credit Cards
Very little attention has been paid to the fact that, similar to mortgage-backed securities, credit card debt is packaged and sold to investors. Yet credit card receivables are one of the oldest segments of the ABS market.

Credit cards holders may borrow money on an unsecured basis up to the allowable limit set by the issuers. The borrower pays the principal and interest as they choose, but they are required to make at least the stated minimum monthly payment. They can continue borrowing money up to their allowable credit limit. Since there is no payment schedule or maturity date on the outstanding balance, credit card accounts are classified as non-amortizing loans.

Credit card ABS is a $915 billion industry with an alarming rate of payment defaults. Rising payment defaults could unravel the whole game, just as delinquencies in the housing market brought down the $900 billion in mortgaged-backed securities.

Student Loans
There are two basic categories of student loan ABS—private and Federal Family Education Loan Program (FFELP) loans. Private student loans have relatively high default rates, but this is largely neutralized by government guaranteed FFELP loans that that cover most student loans. FFELP loans are at least 97% guaranteed by the Department of Education.

But even with the guaranty, the yield spread on FFELP student loan bonds has widened recently creating income securities which are not significantly exposed to credit risk.

Student loans are amortizing assets; that is, they must be paid off according to a predetermined schedule.

Other Assets
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. The latest class in the news is the royalties payable to celebrity entertainers and rock stars from a specified collection of their works.

Financial institutions that originate (Originators) and package ABS enjoy benefits without bearing the associated risks. By pooling these assets and selling them, the Originators reduce their risk-weighted assets and free up their capital for originating still more loans.

If the pooled assets in the ABS turn sour, the institution that purchases them pays the price of bankruptcy, not the Originator. The Originator earns fees from having made the original mortgage loans to consumers, and they receive fees from servicing the assets throughout their life.

See also Mortgage-backed Security.

Valuable Resources

Previous Blog Entries