What are “Asset-Backed Securities”?
Asset-backed securities (“ABS”) are financial instruments backed by collateral in the form of income-generating financial assets.
The underlying assets usually generate cash flows typically from debts such as credit card receivables, home equity loans, student loans, and auto loans.
As many of the loans cannot be sold separately, they can be pooled together and converted into marketable asset-backed securities through a process known as ‘securitization’ (see explanation below). The repayments on these loans is used to pay the interest to ABS holders. The creation of ABS provides investors with further investment opportunities, and financial institutions often use ABS to remove risky assets from their balance sheets.
Key Learning Points
- Asset-backed Securities are financial instruments that are backed by income-generating assets.
- The underlying assets of an ABS are often illiquid and can’t be sold on their own, so ABS can be used to create liquidity for those assets.
- Financial institutions will pool multiple small and illiquid assets together through a process known as securitization.
- Investors who invest in asset-backed securities benefit from the opportunity to invest in a wide range of income-generating assets as each security only contains a fraction of the total pool of underlying assets.
- ABS results in new securities with a diversified risk profile. Both the risk, interest, and principal payments on the assets are passed on to the investor.
- ABS can provide investors access to securities with profiles that match their risk, return, and maturity needs that are otherwise not directly available.
The Securitization of Assets
The securitization process transfers ownership of assets (such as loans or receivables) from the original owner(s) into a separate legal entity. The legal entity then issues securities, using the asset cash flows to pay interest and repay the principal amount to the investor(s). In the process, loans and other forms of debt are pooled together and typically structured into various types and tranches of ABS. The interest and principal payments are passed on to the investor(s). At the same time, the risk of default is minimized as each ABS only contains a fraction of each underlying asset. Each pool is separated based on the level of risk. Lower-risk assets will command lower interest payments, while riskier assets may provide a higher yield.
The Benefits of Asset-Backed Securities
Asset-backed securities provide the following benefits:
- Risk management and mitigation against losses from the potentially risky lending activity.
- Originators of ABS are able to minimize their risk-weighted assets and free up capital to originate more loans through the sale of the ABS.
- Investors can directly access liquid investments and payment streams that would otherwise be unattainable if all the financing were performed through banks.
- Banks are able to scale up their loan originations to a greater extent than if they used only their in-house loan portfolios.
The Downsides of Asset-Backed Securities
Asset-back securities bring the following downsides:
- The underlying assets are often harder to perform due diligence on.
- There is a possibility of lower yield from prepayments. However, this can be mitigated at the origination stage by incorporating prepayment penalties on the borrowers.
- Potential widespread defaults during an economic downturn.
Assume that Bank A has a loan portfolio that contains 600 outstanding residential loans. The average worth is £2m with 15 years maturity and an interest rate of 7.5%.
The total portfolio of Bank A’s residential loans is £1.2bn (600x£2m). The borrowers pay interest, and the principal amount will be repaid on maturity.
Bank A sets up a wholly-owned SPV that purchases the residential loan portfolios for £1.2bn plus any bank fees. The annual cash flow from the loan portfolio for the next 14 years will be £90 million (= 7.5% * £1.2 billion), and in the 15th year, it will be £1.29billion (= £1.2 billion + £90million)
The SPV will structure the pool of residential loans into asset-backed securities. Assume it structured 1,000 units worth £1.2million each with a maturity of 15 years and sells them to the capital market investors. The ABSs will yield a slightly lower return than the underlying assets as the SPV will incorporate its fees for bearing the credit risk.
Asset-backed securities (ABS) are pools of assets that are packaged and sold to investors as securities. The underlying assets are usually classified into tranches according to the perceived risk level of the underlying asset.
Download the accompanying Excel files to test your knowledge of asset-backed securities.