Asset-backed security

A financial security backed by either a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are alternatives to investing in corporate debt. They are a type of bond that is based on pools of assets. They are Bonds or notes backed by loan paper or accounts receivable originated by banks, credit card companies, or other providers of credit; not mortgages.

Conceptually, the structure is similar to a mortgage-backed security (MBS). MBSs are backed by mortgages—fixed rate, floating rate, residential, commercial, single family, multi-family, etc. ABSs are backed by non-mortgage assets. This includes auto loans, credit card receivables, home equity loans, student loans, etc. Due to government guarantees, MBSs typically entail no credit risk. ABSs generally lack such guarantees, so they entail credit risk. Due to diversification of the underlying assets, as well as credit enhancements, that risk tends to be modest. ABSs can be subject to prepayment risk, but this is slight compared to MBSs. Consumers are more likely to refinance a home than an auto in response to a drop in interest rates. ABSs are appealing to issuers because the structure allows them to get assets off balance sheets, freeing up capital for further receivables. Also, ABSs make it possible for issuers whose unsecured debt is below investment grade to sell investment grade—even AAA-rated—debt. To create an ABS, a corporation creates a special purpose vehicle to which it sells the assets. While is is common to speak of the corporation as the issuer of the ABS, legally, it is the trust or special purpose vehicle that is the issuer. It sells securities to investors. To protect investors from possible bankruptcy of the corporation, there are three legal safeguards: Transfer of assets from the corporation is a non-recourse, true sale. Investors receive a perfected interest in the assets' cash flows. A non-consolidation legal opinion is obtained certifying that assets of the trust or special purpose vehicle cannot be consolidated with the corporation's assets in the event of bankruptcy.

Not surprisingly, asset-backed securities evolved out of the MBS market, which developed in the seventies when interest rates surged and thrift institutions found themselves saddled with residential mortgages that were earning less than what they were paying for deposits. Compared with mortgage-backed securities, asset-backed issues have been relatively unaffected by swings in interest rates. The reason is that the car loans and other loans backing the securities have shorter maturities than mortgages, and therefore people are less likely to refinance when interest rates fall. In that respect, asset-backed securities resemble noncallable bonds.

This new market was born in early 1985, when the Sperry Lease Finance Corporation, a special-purpose organization set up by Sperry Corporation (now Unisys), sold to institutional investors $192.4 million in fixed-rate notes collateralized by computer leases. Managed and structured by First Boston Corporation, that deal enabled Sperry to offset rising marketplace resistance to its conventional debt, which was hindering the company's efforts to lease new equipment. Another early milestone came in October 1986, when GMAC issued $4 billion in notes backed by automobile loans.

Although legal devices used to package nonmortgage assets are similar to those used for mortgage-backed securities, there are several differences. For one thing, mortgage-backed securities are guaranteed by U.S. government agencies. In contrast, issuers of asset-backed securities typically gain a top investment-grade rating by selling the assets into a "bankruptcy-proof" entity, called a special-purpose company or trust, and cushioning investors against loss of principal with one or more kinds of credit support. This so-called "credit enhancement" takes a variety of forms, including letters of credit from top-rated commercial banks, third-party guaranties, reserve funds, recourse to the parent company, and cash collateral accounts, which lately have overtaken letters of credit as the method of choice for major public transactions. So far, these securities have stood up extremely well on the rare occasions when issuers have run into rough financial seas. The concept passed a crucial test in mid-1991, when Miami's troubled Southeast Bank was forced to pay out early on a $300 million credit card issue. According to Walid Chammah, managing director of First Boston's asset finance unit, "Investors haven't been hurt in any transaction that was structured and rated."

A significant advantage of asset-backed securities is that they bring together a pool of financial assets that otherwise could not easily be traded in their existing form. By pooling together a large portfolio of these illiquid assets they can be converted into instruments that may be offered and sold freely in the capital markets.

An ABS is essentially the same thing as a mortgage-backed security, except that the securities it backs are assets such as loans, leases, credit card debt, a company's receivables, royalties and so on, and not mortgage-based securities.

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)

In 2001 the Bank of Japan added it is ready to provide cash beyond the stated targets if the money market shows any signs of instability. The announcement also included a proposed expansion of policy tools, focusing on the use of commercial paper and asset-backed securities.

For investors, ABSs are an alternative to highly-rated corporate debt. They generally offer similar or superior liquidity. Because the underlying assets are diversified, they are less subject to credit surprises.

ABSs can be structured into different classes or tranches, much like collateralized mortgage obligations (CMOs). There may be senior or subordinated classes of debt, which have different credit ratings. Tranches may be structured with different average maturities. Choice of structure depends upon investor demand as well as the nature of the underlying assets.

Chicago Stock_Exchange

Electronic Communication Network

government_bond information
Other Lonympics sites

An Index of web pages on the subject of Shares, Stocks, FOREX and Finance