An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized (or "backed") by a specified pool of underlying assets.
The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can vary from common payments on credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments, or movie revenues.
Often a separate institution, called a special-purpose vehicle, is created to handle the securitization of asset-backed securities. The special-purpose vehicle, which creates and sells the securities, uses the proceeds of the sale to pay back the bank that created, or originated, the underlying assets.
The special-purpose vehicle is responsible for "bundling" the underlying assets into a specified pool that will fit the risk preferences and other needs of investors who might want to buy the securities, for managing credit risk – often by transferring it to an insurance company after paying a premium – and for distributing payments from the securities. As long as the credit risk of the underlying assets is transferred to another institution, the originating bank removes the value of the underlying assets from its balance sheet and receives cash in return as the asset-backed securities are sold, a transaction which can improve its credit rating and reduce the amount of capital that it needs. In this case, a credit rating of the asset-backed securities would be based only on the assets and liabilities of the special-purpose vehicle, and this rating could be higher than if the originating bank issued the securities because the risk of the asset-backed securities would no longer be associated with other risks that the originating bank might bear. A higher credit rating could allow the special-purpose vehicle and, by extension, the originating institution to pay a lower interest rate (and hence, charge a higher price) on the asset-backed securities than if the originating institution borrowed funds or issued bonds.
Thus, one incentive for banks to create securitized assets is to remove risky assets from their balance sheet by having another institution assume the credit risk, so that they (the banks) receive cash in return. This allows banks to invest more of their capital in new loans or other assets and possibly have a lower capital requirement.
Definition An "asset-backed security" is sometimes used as an umbrella term for a type of security backed by a pool of assets,assets that otherwise could not be traded has been securitized. MBS and CDO compared: an empirical analysis and sometimes for a particular type of that security – one backed by consumer loans or loans, leases or receivables other than real estate. In the first case, collateralized debt obligations (CDO, securities backed by debt obligations – often other asset-backed securities) and mortgage-backed securities (MBS, where the assets are mortgages), are subsets, different kinds of asset-backed securities. (Example: "The capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs". (italics added)). In the second case, an "asset-backed security" – or at least the abbreviation "ABS" – refers to just one of the subsets, one backed by consumer-backed products, and is distinct from a MBS or CDO, (example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO .... Securitization issues backed by consumer-backed products – car loans, consumer loans and credit cards, among others – are called ABSsee also
Structure United States On January 18, 2005, the United States Securities and Exchange Commission (SEC) promulgated Regulation AB which included a final definition of Asset-Backed Securities."Financial Services Alert" Goodwin and Procter, January 18th 2005, Vol. 8 NO. 22
"Definition of ABS. The term "asset-backed security" is currently defined in Form S-3 to mean a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period plus any rights or other assets designed to assure the servicing or timely distribution of proceeds to the security holders. The SEC has interpreted the phrase "convert into cash by their terms" to exclude most assets that require active behavior to acquire cash – such as the selling of non-performing assets and physical property. It has also interpreted the phrase "discrete pool" to exclude those that can change in composition over time.
Lease-Backed Securities. The new rule expands the definition of "asset-backed security" to include lease-backed securities as long as the residual value of the leased property is less than 50% of the original securitized pool balance (or less than 65% in the case of motor vehicle leases). However, such securities may be shelf-registered on Form S-3 only if the residual value of the leased property represents less than 20% of the original securitized pool balance (or less than 65% in the case of motor vehicle leases).
Delinquent and Non-performing Assets. The new rules provide that a security may be considered to be an "asset-backed security" even if the underlying asset pool has total delinquencies of up to 50% at the time of the proposed offering as long as the original asset pool does not include any "non-performing" assets. However, consistent with current practice, shelf registration on Form S-3 will be available only if delinquent assets constitute 20% or less of the original asset pool. An asset is considered to be non-performing if it satisfies the charge-off policies of the sponsor (or applicable bank regulatory agencies) or if it would be considered a charged-off asset under the terms of the applicable transaction documents.
Exceptions to the "Discrete Pool" Requirement. The new rules generally codify the SEC staff’s position that a security must be backed by a discrete pool of assets in order to be considered an ABS. However, the new rules establish the following exceptions to address market practices.
(1) Any security issued in a master trust structure would meet the definition of "asset-backed security" without limitation.
(2) "asset-backed securities" will also include securities with a prefunding period of up to one year during which up to 50% of the offering proceeds (or, in the case of master trusts, up to 50% of the aggregate principal balance of the total asset pool whose cash flows support the ABS) may be used for subsequent purchases of pool assets.
(3) The new rules also include within the definition of "asset-backed security" securities with revolving periods during which new financial assets may be acquired. In the case of revolving assets such as credit cards, dealer floorplan and home equity lines of credit, there is no limit to the length of the revolving period or the amount of new assets that can be purchased during that time. For securities backed by receivables or other financial assets that do not arise under revolving accounts, such as automobile loans and mortgage loans, an unlimited revolving period will be permitted for up to three years. However, the new assets added to the pool during the revolving period must be of the same general character as the original pool assets.
According to Thomson Financial League Tables, US issuance (excluding mortgage-backed securities) was: 2004: USD 857 billion (1,595 issues) 2003: USD 581 billion (1,175 issues)
Types
Home equity loans Securities collateralized by home equity loans (HELs) are currently the largest asset class within the ABS market. Investors typically refer to HELs as any nonagency loans that do not fit into either the jumbo or alt-A loan categories. While early HELs were mostly second-lien subprime mortgages, first-lien loans now make up the majority of issuance. Subprime mortgage borrowers have a less-than-perfect credit history and are required to pay interest rates higher than what would be available to a typical agency borrower. In addition to first- and second-lien loans, other HE loans can consist of high loan to value (LTV) loans, re-performing loans, scratch and dent loans, or open-ended home equity lines of credit (HELOC), which homeowners use as a method to consolidate debt."Fixed Income Sectors: Asset-Backed Securities: A primer on asset-backed securities", Dwight Asset management Company 2005
Auto loans The second-largest subsector in the ABS market is auto loans. Auto finance companies issue securities backed by underlying pools of auto-related loans. Auto ABS are classified into three categories: prime, nonprime, and subprime: Prime auto ABS are collaterized by loans made to borrowers with strong credit histories. Nonprime auto ABS consist of loans made to lesser credit quality consumers, which may have higher cumulative losses. Subprime borrowers will typically have lower incomes, tainted credited histories, or both. Owner trusts are the most common structure used when issuing auto loans and allow investors to receive interest and principal on sequential basis. Deals can also be structured to pay on a pro-rata or combination of the two.
Credit card receivables Securities backed by credit card receivables have been benchmark for the ABS market since they were first introduced in 1987. A credit card holder may borrow funds on a revolving basis up to an assigned credit limit. The borrower then pays principal and interest as desired, along with the required minimum monthly payments. Because principal repayment is not scheduled, credit card debt does not have an actual maturity date and is considered a nonamortizing loan.
ABS backed by credit card receivables are issued out of trusts that have evolved over time from discrete trusts to various types of master trusts of which the most common is the de-linked master trust. Discrete trusts consist of a fixed or static pool of receivables that are tranched into senior/subordinated bonds. A master trust has the advantage of offering multiple deals out of the same trust as the number of receivables grows, each of which is entitled to a pro-rata share of all of the receivables. The delinked structures allow the issuer to separate the senior and subordinate series within a trust and issue them at different points in time. The latter two structures allow investors to benefit from a larger pool of loans made over time rather than one static pool.
Student loans