What is an Asset-Backed Security?
entitled to the cash flow
s from a specified pool of asset
s. ABSs are a type of derivative
. Specifically, ABSs are the product of the securitization
of a particular asset. Securitization
is the pooling of monetary assets with predictable cash flows and sale of said assets to a specially created third party, which has borrowed money to finance the purchase.
Note: In the United States, the powers that be have decided it wise to separate securities backed by mortgages, or mortgage-backed securities, from all other types of asset-backed securities. Therefore, ABSs are a whole different product than MBSs. In the rest of the world, however, logic dictates that MBSs, being created and managed in quite the same manner as securities backed by all other types of assets, are simply a subset of ABSs. Silly old SEC.
ABSs can be backed by any type of asset that a company wants to get rid of. Mortgages, credit card receivables, life insurance policy loans, mobile home loans, home-equity loans, even junk bonds have been securitized.
The issuer of the security, which owns a pool of assets, sets up a Special Purpose Vehicle, or SPV, whose purpose is the management of the security and cash flows from the assets. The SPV then borrows money from investors to finance the purchase of the pool of assets from the issuer. To recap:
- The seller trades its receivables for cash with an SPV.
- The SPV pools the receivables and trades shares of the receivables to investors for cash.
- The SPV channels all cash flows from the receivables directly to the investors in the form of dividends.
How Was the Asset-Backed Security Invented, and Why?
The baby boomers are nearly single-handedly responsible for creating the need for this powerful financial instrument. In the mid-1970s the baby boomer generation began to buy up homes, having reached the home-and-family stage of their lives, and the demand was pushing home costs up 6% annually. Banks, credit unions, and savings and loans, hitherto the primary sources for home funding, found themselves unprepared for the explosion in demand for mortgages. Having always simply borrowed from depository accounts to fund the fixed-rate loans, attracting enough capital to fund new loans became a problem.
Since no solution was forthcoming from Wall Street, the government, or the banks themselves, and since increases in mortgage rates failed to quell the demand (by the early 80s home loan rates were in the double digits), the issue swiftly evolved from affordability of mortgages to availability of mortgages. It was commonly feared that within ten years there simply would not be any funds left with which to issue new mortgages.
The Bank of America worked closely with some senior officers at Salomon Brothers to find a way out of the home funding problem, with the objective of providing cash to banks. The first several attempts at providing liquidity to the banks, which were all failures, included coupon bonds using mortgages as collateral and a mortgage-backed security prototype which only failed when faced with legal and tax barriers of the time (only after issuing this prototype did the gentlemen at Bank of America find that the investment was only legal in 15 of 50 states!). By this point, about 1980, the banks were reaching crisis point, as deposits were being lost to the increasing free-market rate. Not only was demand increasing, but the balance sheets of the banks were shrinking.
It took until 1985 for Bank of America to fully achieve their goals, which included changes to the tax code which allowed cash flows to pass from home loans to mortgage-based securites, tax free, and development of technologies which would allow easier bookkeeping of securities which earned interest monthly rather than semi-annually (the technology barrier would actually prove the most difficult – computers through the 70s and early 80s were rare, cumbersome, and expensive, often making automated bookkeeping more trouble than it was worth). These changes, which made the mortgage-backed security cheaper and simpler than its earlier prototypes, finally sparked some much-needed growth in the mortgage market. The banks were provided cash, the investors with earnings, and the baby boomers with homes at rates they could afford.
About 5.8 seconds after the mortgage-backed security was recognized as a success, companies and banks turned their attention to other types of securities which could be sold. Chrysler Financial was quick to offer one of the first asset-backed securities, backed by automobile loans. Mobile home loans, home-equity loans, life insurance policy loans, credit card receivables, and even junk bonds were all gathered, packaged, and sent back out as an asset-backed security. The market exploded well through the 1990s, and now the total mortgage- and asset-backed security market is valued at well over $4 trillion.
Why are Asset-Backed Securities So Great?
From the Seller/Issuer Perspective
With a balance sheet heavy in receivables and low on cash, companies are often in search of ways to provide liquidity without sacrificing profitability. ABSs do just that; the receivables are sold to investors, many times removing them from the balance sheet, and the much-needed cash is provided and free for use. Companies with poor credit ratings on an unsecured basis have a way of offering much higher quality, even AAA rated, secured credit. If the transaction meets the criteria for sale treatment, these being legal isolation of the seller from the asset, rights of the new owner over the asset, and the relinquishing of the right to recall the security (often a right held with a corporate bond), then the asset can be removed from the company’s balance sheet. In other words, if the government recognizes that the company actually sold the asset, rather than financed it, then the company can subtract the receivable from its balance sheet and add in its place the cash earned from the sale.
Removal from the balance sheet can, in some cases, improve the company’s ROE and other important financial ratios. In addition, the tax bills pushed through by the inventors of the security eliminated taxation of the cash flows as they moved from the issuer to the investor, allowing the company to give the transaction tax treatment as a financing event, even though the same event is given accounting treatment as a sale. Finally, securitization offers a cost-efficient method of diversifying funding sources, making it an attractive option even for firms with excellent credit ratings.
From the Investor Perspective
For investors, ABSs are an excellent alternative to 10 year treasuries. The securities are often very well rated, usually higher than corporate bonds issued by the very same company, since the creditworthiness of the issuer is completely irrelevant and the individual risks from the receivables are pooled. The security is most often more liquid than a corporate bond, given the nature of the receivables (Homeowners, on average, change homes – and mortgages – every seven years, cars every three years). The combination of high rating, relatively high yield, low volatility, and high liquidity make this security very attractive for investors.
From the Consumer/Borrower Perspective
After almost ten years of funds availability problems, the invention of the mortgage-backed security fairly well rescued banks from a potential funds crisis. Mortgages and other forms of credit are available more readily than ever and more cheaply, from more sources, thanks largely to asset-backed securities. Since ABSs were so efficient in lowering costs for moving funds from the investor to the borrower, the consumers enjoy a much more diverse and competitive market for home and auto loans, credit cards, and other types of credit.
From the Investment Banker Perspective
Moving billions of dollars per day in the MBS/ABS markets certainly has its benefits for investment bankers, most notably in their wallets. A new product line with plenty of room for expansion and innovation gives investment bankers breathing room for acquiring new accounts and generating new fees.
What’s the Catch?
Certainly, there ought to be one. ABSs sound too good to be true, at this point. In the 1980s, one problem that was still be ironed out even after the tax, accounting, legal issues had been resolved was the technology barrier. Accountants and financial managers were accustomed to bonds which earned interest semi-annually. ABSs, which earn interest monthly (to reflect the payment plans and interest accruals on the assets which comprise them), require six times the paperwork to track the same amount of money. But even that problem has disappeared, with technology advancing to the point where, with today’s computers, tracking investments with daily interest accruals seems like a walk in the park.
There was one catch for the banks and savings and loans which MBSs and ABSs sought to save. Ginnie Mae, Fannie Mae, and Freddie Mac, all government-sponsored entities (GSEs) were among the first to offer these new securities, and use the resulting liquidity to issue new mortgages. As a result, consumers are increasingly taking out mortgages through these organizations rather than through the banks, which previously held a monopoly on the supply and pricing of mortgages. Even now, the mortgage market is being increasingly dominated by the GSEs, who are taking over market share from the banks and savings and loans.
Finally, in the case of the mortgage-backed security, the very efficiency of the system is undermining the value of the mortgage as an investment. Because of up-front loan points and other costs associated with initiating a mortgage, mortgages used to have a built-in call protection. There was a degree of certainty that the mortgage would not be called away from the investor by borrowers seeking to save money by refinancing. The streamlining of the process of moving funds between borrowers and investors has all but eliminated these costs, making it very simple, cheap, and extremely advantageous for the borrower to refinance when rates drop as little as .25%. The investor, having hoped that the mortgage would be around for a number of years, loses out.
On the other hand, if interest rates rise, the duration of the security increases, and the investor loses out again (because they aren't making as much as they could with another security, and if they try to sell their share in the security, it is now officially a "crappy security," and the price will be lower). The only way out of this Catch-22 is if mortgage rates rise across the board to compensate investors for the new refinancing risk. The very changes which were intended to be so fabulous for the market have actually damaged it. The same phenomenon can be seen in the credit card receivables-backed security market, where companies are scrambling to offer consumers “teaser rates” to get them to transfer their balances, calling the receivable away from the original investor, and incurring a risk of repeated debt transfer to the new investor.
MBSs and ABSs seem like the perfect product: the ugly assets are dressed up and sent out the door to be sold in a market where everybody wins. However, there are subtle yet serious market consequences to the rise of these derivatives, which, though preventable, are the sort of hazard that is not often seen until it is too late. Perhaps, if the powers that be keep a watchful eye on problems such as the refinancing rush and other market phenomena, MBSs and ABSs can be fine-tuned until they actually are a near-perfect product.
BROOKS, Donald E., and HERZ, Robert H. Guide to Financial Instruments. Third Ed. New York: Coopers & Lybrand, 1994.
FABOZZI, Frank J. Issuer Perspectives on Securitization. New Hope, PA: Frank J. Fabozzi Associates, 1998.
FISHMAN, Michael J., and KENDALL, Leon T. A Primer on Securitization. Cambridge, MA: MIT Press, 1996.
HAYRE, Lakhbir. Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities. New York: John Wiley & Sons, 2001.