What are asset backed securities
What are asset backed securities and why are we discussing them on our company blog?
Asset backed securities, called ABS, are bonds or loan notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.
They also can be secured against the property portfolios of large established property developers or corporations or on other securitised assets. Asset Backed Securities differ from most other kinds of bonds in that their creditworthiness (which is at the triple-A level for more than 90% of outstanding issues) derives from sources other than the paying ability of the originator of the underlying assets.
Financial institutions that originate loans—including banks, credit card providers, auto finance companies and consumer finance companies—turn their loans into marketable securities through a process known as securitisation. The loan originators are commonly referred to as the issuers of ABS, but in fact they are typically the sponsors, not the direct issuers, of these securities.
These financial companies sell pools of loans to a special-purpose vehicle (SPV), whose sole function is to buy such assets in order to securitise them.
The SPV, which is usually a corporation, then sells them to a trust. The trust repackages the loans as interest-bearing securities and actually issues them. The “true sale” of the loans by the sponsor to the SPV provides “bankruptcy remoteness,” insulating the trust from the sponsor.
The securities, which are sold to investors by the investment banks or brokers that underwrite them, are “credit-enhanced” with one or more forms of extra protection—whether internal, external or both.
Asset Backed Securities constitute a relatively new but fast-growing segment of the debt market. The first ABS were issued in 1985; in that year, the market for publicly offered ABS issues was $1.2 billion. In 2003, issuance totaled a new record of $479.4 billion. This article primarily addresses publicly issued ABS, although the growing private-issue ABS market is briefly mentioned. It is estimated that a total of over $2.6 trillion of Asset Backed Securities were issued from 1985 through 2003 and the market continues to grow.
Five important facts about Asset-Backed Securities
1. Asset Backed Securities provides exposure to the real economy
Because the assets of the underlying ABS consist of mortgages, loans to individual consumers or small and medium-sized businesses, an ABS investor has direct exposure to the real economy. That is not possible in a similar manner for many other fixed income categories.
The European Central Bank (ECB), in particular, has been very vocal about this. Besides the fact that the ECB has faith in the concept and in the quality of the asset class in general, it regards ABS as a way to invest money directly in the real economy.
2. The underlying risk of an Asset Backed Security is transparent
The European DataWarehouse was set up on the initiative of the ECB, among others, in 2009, with the objective of pooling, validating and making available detailed data on the loans underlying an ABS. Whereas in the past it was unusual to provide investors with loan-level data, despite the fact that the pool of loans was static and known, nowadays this is becoming the norm. In the past there were summaries, in which the loans were grouped and categorised. The provision of (anonymised) data per loan at the time of issue and the transparency of information during the life of the ABS, thanks to initiatives like European DataWarehouse, make the market and the attached risks even more transparent.
3. Asset Backed Securities are unaffected by bankruptcy of the originator
ABS are structured in such a way that the loans, including the rights attached to the collateral, are sold by the originator to a special purpose vehicle (SPV) established specifically for that purpose. The purpose of this is to ensure that in the event of the bankruptcy of the originator, the investors will be protected and the underlying loans will not be included with the liquidated assets. The value of the underlying loans is purely and solely for the benefit of the investor in the securitisation.
4. The 5% retention requirement ensures alignment of the interests of all parties concerned
Since 2011, European investors may only invest in securitisations where the originator/sponsor of the deal retains 5% of the risk exposure. This can be effected by means of a horizontal representation (e.g. in the form of the first loss tranche), a vertical representation (5% of each tranche of the deal) or in the form of randomly selected loans with similar conditions amounting to 5% of the outstanding ABS.
The imposition of this rule gives the originator of the ABS a motive to safeguard the credit quality of the ABS. Whereas in the past, the originator could sell the (pool of) loans (and the attached risk) in their entirety to the SPV, it is now exposed to at least 5% of the same risk. The originator is thus motivated to ensure the loans are of good quality.
5. The actual losses realised by European Asset Backed Securities are limited
Despite the asset class’s negative image, the losses actually realised within European ABS are limited. A report by credit rating agency Fitch shows that of all the Fitch-rated securitisations issued between 2000 and 2014, only 0.25% losses were realised. By comparison, in US securitisations this was 2.9% in the same period.
Absolutely no losses were realised on bonds in the sectors Dutch RMBS and UK Prime RMBS. The limited losses were seen mainly in the sectors Commercial Mortgage Backed Securities (CMBS) and Structured Credit (e.g. collateralised debt obligations or CDOs). The categories that generated (limited) losses within RMBS were Spanish RMBS, issued in 2006/2007 at the peak of the Spanish housing market, and UK non-conforming RMBS.
The distinct difference in performance between the United States and Europe can be explained by several factors:
- The first factor is of a cultural nature: the stigma attached to debt default and personal bankruptcy is often much greater in European jurisdictions than in the United States.
- A second factor is a legal issue: residential mortgages in Europe typically involve full recourse to the borrower. Full recourse means that the lender can pursue the borrower for any outstanding amount after the house has been repossessed and sold. The borrower cannot simply return the house keys to the lender and then walk away.
- European jurisdictions, with the exception of some critical regions (Spain, Ireland and to a certain extent the Netherlands), did not typically witness the same levels of aggressive pre-crisis mortgage loan underwriting seen in the United States, especially in relation to the US sub-prime mortgage market.