Asset-Backed Security

What Is An Asset-Backed Security?

Asset-backed securities (ABS) are fixed-income instruments similar to bonds that are collateralised by a pool of loans, the payments on which are channeled to the holders of the securities in the form of interest payments. When the loans are paid off, holders of the ABS receive their principal back.

ABS issues are structured by a lender or investment firm using different types of loans. The types include residential and commercial mortgages, auto loans, credit card loans, home equity loans, student loans, boat loans and other types of debt. The process of putting ABS issues together is called securitisation.

Technically, ABS generally refers to deals that are not secured by mortgages. Issues backed by residential mortgage loans are called mortgage-backed securities (MBS or RMBS), while those backed by commercial mortgages, such as on office buildings, apartments, malls and the like, are called commercial mortgage-backed securities, or CMBS. However, the term ABS can encompass all varieties of loans.

Issuers Of ABS

Asset-backed securities are usually issued by the company that made the loans, such as a bank or automobile manufacturer, or a government entity, such as Fannie Mae and Freddie Mac in the U.S., which buy mortgages from lenders and then securitise them. By securitising their loans, lenders can free up their balance sheet to make more loans. Many Wall Street firms also aggregate loans from a variety of lenders and securitise them into bonds that they issue.

As a result, holders of the ABS are dependent on the income stream from the loans, not the underlying issuer. For example, when Ford Motor Co. sells ABS backed by its auto loans, the investors are relying on the individual borrowers to make their monthly debt payments and to pay back their loans, not Ford, which is not legally obligated to pay the securities back.

In some cases, investors are better off that way, as the income stream from the loans may be stronger than the issuing company's credit strength. This is why many companies sell ABS rather than debt they are obligated to repay.

ABS Credit Risk

ABS deals, which sometimes include thousands of individual loans, are usually structured in order to receive a triple-A rating from a credit rating agency. The deals include more loans than are necessary to repay investors to cover the likelihood that some percentage of borrowers will default on their loans.

The failure of many such deals, particularly MBS, to live up to their triple-A ratings was a consummate cause of the 2008 financial crisis. In the runup to the crisis, many mortgage lenders in the U.S. and elsewhere made loans to high-risk borrowers, including those with low credit scores, low down payments, poor work histories, and the like, and many of the borrowers defaulted.^[1]

Not only did many borrowers commit fraud by inflating or falsifying their incomes in order to qualify for loans, but many lenders were complicit in their zeal to make more loans. The investment bankers who then put the MBS deals together were sometimes also complicit, as were the rating agencies that certified the deals with high credit ratings.

Since the crisis, numerous investment and commercial banks in the U.S. and Europe have been fined tens of billions of dollars by their governments for defrauding investors by failing to disclose the true risky nature of the securities they sold.^[2]

Prepayment And Reinvestment Risk

In addition to credit risk, another risk investors in ABS and MBS face is prepayment risk, which means they stand to get their principal back earlier than they had anticipated, while also receiving fewer interest payments. Generally, this is not a concern for holders of traditional bonds, which have stated interest payment dates and maturity dates.

Asset-backed securities have estimated maturity dates, but as borrowers pay off their loans, sometimes ahead of schedule, that money is returned to the ABS holders. As a result, if they originally bought the ABS assuming that the bonds would mature in 10 years, they may get their money back earlier, like in five or seven years. This usually happens in a falling interest rate environment, so the ABS investors must now take their money and invest it in securities that pay even less.

For example, let's say the investor bought a US$10,000 MBS that paid 5% a year in interest and had an estimated maturity date of 20 years. A year later, however, interest rates have fallen, which encourages many homeowners to refinance their mortgages into lower-rate loans, thus paying off their existing loans. When those earlier mortgages are paid off, the holders of the MBS backed by those higher-rate loans get their money back. Now, with market interest rates lower, they must reinvest their money in MBS that pays only 4.5%.^[3]

Generally, ABS and MBS yield more than traditional bonds issued by governments and corporations, which makes them attractive to investors and compensates them somewhat for prepayment and reinvestment risk. Investors can purchase ABS and MBS directly or through mutual funds and exchange-traded funds (ETFs) that buy them.

Summary

Asset-backed securities are fixed-income instruments that are collateralised by a pool of loans, usually residential and commercial mortgages and consumer loans, including auto loans and credit card loans. The process of putting ABS issues together is called securitisation.