Asset Backed Securities: a practical guide for investors.

AuthorMelennec, Olivier

This guide is an introduction to ABS, presented from the point of view of the investor. It proposes a breakdown in simple notions, which enable a partial reading.

  1. What is an ABS?

    ABS (Asset Backed Securities) are experiencing strong growth on the capital markets. These financial instruments enable companies to raise capital using the securitisation method described below.

    1. Securitisation

      Securitisation is a way for companies to raise capital and consists in using one of the company's financial assets to guarantee a security issued on the capital markets.

      Let us take the example of an industrial manufacturer with an average credit rating, who is experiencing difficulties in obtaining financing from banks. This manufacturer has sold capital goods to customers with a strong credit rating. The idea behind securitisation is to structure a financing package backed by these high quality trade account receivables. In this way repayment no longer depends on the manufacturer, but only on the customers' ability to pay for the goods.

      A company is created for this purpose (SPV or Special Purpose Vehicle). The manufacturer (the Seller) sells the portfolio of trade account receivables (the underlying asset) to the SPV. The SPV then refinances this purchase by issuing rated securities, with repayment of these debts depending on the customers' (the final debtors') ability to pay.

    2. ABCP, MBS and ABS

      Securities issued using the securitisation method are called "Term Deal?' if they are offered to the markets as a long-term bond and "Conduit? if they are short-term.

      1. ABCP

        Conduits are mainly refunded by issuing commercial paper. These securitisation programmes, known as Asset Backed Commercial Paper (ABCP) accounted for a total outstanding of more than USD 500bn in the US in 1999, (i.e. more than a quarter of the US commercial paper market).

      2. MBS

        Term deals where the underlying assets comprise mortgage loans are called Mortgage Backed Securities. These represent a highly specific market and are mainly traded on the US domestic market. MBSs are generally fixed rate and their risk is principally linked to early repayment of the underlying mortgage loans. More than USD 400bn MBSs were issued in the US in 1999.

      3. ABS

        ABSs are all the Term Deals which do not fall under the MBS category: unlike MBSs, ABSs are mostly floating rate notes and principally carry a credit risk. In 1999, approximately USD 350bn of ABSs (excluding MBS) were issued.

    3. Fast-developing

      Since 1996, ABSs have accounted for one of the strongest growth segments in the capital markets and are also developing outside of the US (issuance volume on the European market was USD 75bn in 1999).

      On the whole, this trend can be explained by increasing pressure from shareholders, which leads more and more companies to deconsolidate financial or property assets in order to optimise their Return On Equity (ROE).

      In the same way, information on ABSs is increasingly available and transactions are progressively standardised, leading to more transparency.

      Finally, ABSs are often sold as variable rate securities, and benefit enormously from growth in the credit market, while offering an attractive means of diversifying investments, especially in Europe.

    4. Market segments

      Each securitisation is, to a large extent, characterised by its underlying asset. According to this criteria, the ABS market can be divided into several segments.

      US household debt (around USD 5000bn) represented the first pool of securitisable assets which gave rise to MBSs and to the main ABS categories, according to the type of asset: Credit Cards, Home Equity Loans or HEL (consumer loans secured by mortgages), Auto Loans, and Student Loans.

      The "Credit Card" type of ABS has experienced steady growth over the last ten years and account for the most mature and standardised segment of the market, with USD 50bn of new issues in 1999. US consumer loan organisations do not dispose of a large amount of capital and securitise their outstanding credit card debt heavily: they turn to the markets several times a year and each time sell a portfolio of around USD 1bn of outstanding on thousands of individual debtors over the entire US.

      Since 1996, the increase in ABSs has been greatly helped by CLO, CBO and CMBS securitisation types: to maximise their capital, financial institutions have proceeded with a large scale deconsolidation of their loan portfolios (Collateralised Loan Obligation or CLO), security portfolios (Collateralised Bond Obligation or CBO), or commercial property portfolios (Commercial Mortgage Backed Securities or CMBS). By way of example, the volume of CBOs and CLOs issued worldwide in 1999 was almost twice the volume of "Credit Card" type ABSs issued.

  2. 5 STAGES IN EVALUATING AN ABS

    The main difficulty faced by an investor lies in evaluating the offered security within a reasonable time frame. This section suggests a method of breaking down an ABS into its five component parts: underlying asset, credit enhancement, cashflow mechanics, legal structure and links with the seller.

    1. Stage 1: Underlying Assets

      In a securitisation, the analysis of the underlying asset is crucial: whether the issued securities are repaid depends in the first instance on its strong or weak performance. The main points to study are: the quality of the final debtors, the monitoring of the portfolio the maturity of the receivables, and finally how these loans were set up.

      1. Debtors

        It is possible to distinguish between securitisations where the final debtors are individuals, and those which have companies as the final debtors. Risk linked to a portfolio containing many hundreds of thousands of US households' consumer loans can be seen as purely statistical and strongly linked to the economic environment, whereas a portfolio of, for example, twenty company loans needs to be analysed debtor by debtor, since each one accounts for a larger proportion of the underlying asset.

        The credit risk of securitisations backed by individuals is little correlated to securitisation backed by companies.

      2. Reporting

        When a transaction is set up, credit rating agencies require frequent reporting, following a predetermined set of criteria, to assess the development quality of the underlying asset. For household consumer loan portfolios, global statistical data is enough to describe the portfolio (net yield rate, geographical distribution of debtors). Conversely, ten office blocks will need detailed asset- by-asset reporting (vacancy rate, description of the tenants, rents).

        The Diversity Score is a standardised indicator to measure the diversity of a corporate loan portfolio: if for example, a portfolio of 200 loans has a score of 50, this means that the portfolio is equivalent to a hypothetical group of fifty loans to uncorrelated companies. This calculation, made by credit rating agencies, is based on the correlation between different economic sectors.

      3. Maturity

        To fully understand an underlying asset, a distinction needs to be made between long-term and short-term assets: in order to be refunded by a long-term bond, a portfolio of 30-day commercial debts should be renewable. This means that with the repayments, the SPV will buy new debts from the seller over, for example, a five year reinvestment period.

        On the contrary, a portfolio of 15-year mortgage loans does not require a reinvestment period. This portfolio is referred to as static: it does not change during the course of the transaction and is amortised with...

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