Asset-backed security

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,[1] and sometimes for a particular type of that security – one backed by consumer loans[2] or loans,
leases or receivables other than real estate.[3] 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)[2]). 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 ABS[2][4]

Structure
On January 18, 2005, the United States Securities and Exchange Commission (SEC) promulgated
Regulation AB which included a final definition of Asset-Backed Securities.[5]

"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] {lacks definition} 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.[6]

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.[6]

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.[6]
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.[6]

Student loans

ABS collateralized by student loans (“SLABS”) comprise one of the four (along with home equity loans,
auto loans, and credit card receivables) core asset classes financed through asset-backed securitizations and
are a benchmark subsector for most floating rate indices . Federal Family Education Loan Program
(FFELP) loans are the most common form of student loans and are guaranteed by the U.S. Department of
Education ("USDE") at rates ranging from 95%–98% (if the student loan is serviced by a servicer
designated as an "exceptional performer" by the USDE the reimbursement rate was up to 100%). As a
result, performance (other than high cohort default rates in the late 1980s) has historically been very good,
and investors' rate of return has been excellent. The College Cost Reduction and Access Act became
effective on October 1, 2007, and significantly changed the economics for FFELP loans; lender special
allowance payments were reduced, the exceptional performer designation was revoked, lender insurance
rates were reduced, and the lender paid origination fees were doubled. The FFELP loan program ended in
2010, but as of 2020 there was about $245 billion in outstanding debt from 11 million debtors.[7]

A second, and faster-growing, portion of the student loan market consists of non-FFELP or private student
loans. Though borrowing limits on certain types of FFELP loans were slightly increased by the student loan
bill referenced above, essentially static borrowing limits for FFELP loans and increasing tuition are driving
students to search for alternative lenders. Students utilize private loans to bridge the gap between amounts
that can be borrowed through federal programs and the remaining costs of education.[6]

The United States Congress created the Student Loan Marketing Association (Sallie Mae) as a government-
sponsored enterprise to purchase student loans in the secondary market and to securitize pools of student
loans. Since its first issuance in 1995, Sallie Mae is now the major issuer of SLABS and its issues are
viewed as the benchmark issues.

Stranded cost utilities

Rate reduction bonds (RRBs) came about as the result of the Energy Policy Act of 1992, which was
designed to increase competition in the US electricity market. To avoid any disruptions while moving from
a non-competitive to a competitive market, regulators have allowed utilities to recover certain "transition
costs" over a period of time. These costs are considered non-bypassable and are added to all customer bills.
Since consumers usually pay utility bills before any other, chargeoffs have historically been low. RRBs
offerings are typically large enough to create reasonable liquidity in the aftermarket, and average life
extension is limited by a "true up" mechanism.[6]

Others
There are many other cash-flow-producing assets, including manufactured housing loans, equipment leases
and loans, aircraft leases, trade receivables, dealer floor plan loans, securities portfolios, and royalties.[6]
Intangibles are another emerging asset class.[8]

Trading asset-backed securities

"In the United States, the process for issuing asset-backed securities in the primary market is similar to that
of issuing other securities, such as corporate bonds, and is governed by the Securities Act of 1933, and the
Securities Exchange Act of 1934, as amended. Publicly issued asset-backed securities have to satisfy
standard SEC registration and disclosure requirements, and have to file periodic financial statements."[9]

"The Process of trading asset-backed securities in the secondary market is similar to that of trading
corporate bonds, and also to some extent, mortgage-backed securities. Most of the trading is done in over-
the-counter markets, with telephone quotes on a security basis. There appear to be no publicly available
measures of trading volume, or of number of dealers trading in these securities."[9]

"A survey by the Bond Market Association shows that at the end of 2004, in the United States and Europe
there were 74 electronic trading platforms for trading fixed-income securities and derivatives, with 5
platforms for asset-backed securities in the United States, and 8 in Europe."[9]

"Discussions with market participants show that compared to Treasury securities and mortgage-backed
securities, many asset-backed securities are not liquid, and their prices are not transparent. This is partly
because asset-backed securities are not as standardized as Treasury securities, or even mortgage-backed
securities, and investors have to evaluate the different structures, maturity profiles, credit enhancements, and
other features of an asset-backed security before trading it."[9]

The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap rate. For
example, the price of a credit card-backed, AAA rated security with a two-year maturity by a benchmark
issuer might be quoted at 5 basis points (or less) to the two-year swap rate."[9]

"Indeed, market participants sometimes view the highest-rated credit card and automobile securities as
having default risk close to that of the highest-rated mortgage-backed securities, which are reportedly
viewed as substitute for the default risk-free Treasury securities."[9]

Securitization
Securitization is the process of creating asset-backed securities by transferring assets from the issuing
company to a bankruptcy remote entity. Credit enhancement is an integral component of this process as it
creates a security that has a higher rating than the issuing company, which allows the issuing company to
monetize its assets while paying a lower rate of interest than would be possible via a secured bank loan or
debt issuance by the issuing company.

ABS indices
On January 17, 2006, CDS Indexco and Markit launched ABX.HE, a synthetic asset-backed credit
derivative index, with plans to extend the index to other underlying asset types other than home equity
loans.[10] ABS indices allow investors to gain broad exposure to the subprime market without holding the
actual asset-backed securities.

Advantages and disadvantages

A significant advantage of asset-backed securities for loan originators (with associated disadvantages for
investors) 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. The tranching of these securities into
instruments with theoretically different risk/return profiles facilitates marketing of the bonds to investors
with different risk appetites and investing time horizons.

Asset-backed securities provide originators with the following advantages, each of which directly adds to
investor risk:

Selling these financial assets to the pools reduces their risk-weighted assets and thereby
frees up their capital, enabling them to originate still more loans.
Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets
performs very badly, "the owner of ABS (which is either the issuer, or the guarantor, or the re-
modeler, or the guarantor of the last resort) might pay the price of bankruptcy rather than the
originator." In case the originator or the issuer is made to pay the price of the same, it
amounts to re-inventing of the lending practices, restructuring from other profitable avenues
of the functioning of the originator as well as the norms of the issuance of the same and
consolidation in the form of either merger or benchmarking (internal same sector, external
different sector).

This risk is measured and contained by the lender of last resort from time to time auctions and other
Instruments that are used to re-inject the same bad loans held over a longer time duration to the appropriate
buyers over a period of time based on the instruments available for the bank to carry out its business as per
the business charter or the licensings granted to the specific banks. The risk can also be diversified by using
the alternate geographies, or alternate vehicles of investments and alternate division of the bank, depending
on the type and magnitude of the risk.

The exposure of these refinanced loans to "bad credit" (Type II) decisions (particularly in the banking
sector, unscrupulous lending or the adverse selection of credits) is hedged against by the sellers of the same,
or the re-structurers of the same. Thinking of securitization (insurance) as a panacea for all the ills of bad
credit decisions might lead to the hedging of the risk by the transfer of the "hot potato" from one issuer to
another without the actual asset against which the loan is backed reaching an upswing in value, either by
the demand-supply mismatch being addressed or by one of the following factors:

The economic productivity of the business cycle being reversed from downturn to upturn
(monetary and fiscal measures)
More buyers than sellers in the market
A breakthrough innovation.

On a day-to-day basis the transferring of the loans from the

Sub-ordinate debt (freshly made and highly collateralized debt) to the

Sub-ordinate realizable
Sub-ordinate non-realizable
Senior as well as bad (securitized) debt might be a better way to distinguish between the assets that might
require or be found eligible for re-insurance or write – off or impaired against the assets of the collaterals or
is realized as a trade-off of the loan granted against or the addition of goods or services.
This is totally built up in any bank based on the terms of these deposits, and dynamic updation of the same
as regards to the extent of the exposure or bad credit to be faced, as guided by the accounting standards,
and adjudged by the financial and non-market (diversifiable) risks, with a contingency for the market (non-
diversifiable) risks, for the specified types of the accounting headers as found in the balance sheets or the
reporting or recognition (company based declaration of the standards) of the same as short term, long term
as well as medium term debt and depreciation standards.

The issuance of the accounting practices and standards as regards to the different holding patterns, adds to
the accountability that is sought, in case the problem increases in magnitude.

The originators earn fees from originating the loans, as well as from servicing the assets
throughout their life.

The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any
residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. This is
an intrinsic structural flaw in the loan-securitization market that was directly responsible for both the credit
bubble of the mid-2000s (decade) as well as the credit crisis, and the concomitant banking crisis, of 2008.

"The financial institutions that originate the loans sell a pool of cashflow-producing assets to a specially
created "third party that is called a special-purpose vehicle (SPV)". The SPV (securitization, credit
derivatives, commodity derivative, commercial paper based temporary capital and funding sought for the
running, merger activities of the company, external funding in the form of venture capitalists, angel
investors etc. being a few of them) is "designed to insulate investors from the credit risk (availability as well
as issuance of credit in terms of assessment of bad loans or hedging of the already available good loans as
part of the practice) of the originating financial institution".

The SPV then sells the pooled loans to a trust, which issues interest bearing securities that can achieve a
credit rating separate from the financial institution that originates the loan. The typically higher credit rating
is given because the securities that are used to fund the securitization rely solely on the cash flow created by
the assets, not on the payment promise of the issuer.

The monthly payments from the underlying assets – loans or receivables – typically consist of principal and
interest, with principal being scheduled or unscheduled. The cash flows produced by the underlying assets
can be allocated to investors in different ways. Cash flows can be directly passed through to investors after
administrative fees are subtracted, thus creating a “pass-through” security; alternatively, cash flows can be
carved up according to specified rules and market demand, thus creating "structured" securities."[6]

This is an organized way of functioning of the credit markets at least in the Developed Primary non-
tradable in the open market, company to company, bank to bank dealings to keep the markets running,
afloat as well as operational and provision of the liquidity by the liquidity providers in the market, which is
very well scrutinized for any "aberration, excessive instrument based hedging and market manipulation" or
"outlier, volumes" based trades or any such "anomalies, block trades 'company treasury' based decision
without proper and posterior/prior intimation", by the respective regulators as directed by the law and as
spotted in the regular hours of trading in the pre-market/after-hours trading or in the event based specific
stocks and corrected and scrutinized for insider trading in the form of cancellation of the trades, re-issuance
of the amount of the cancelled trades or freezing of the markets (specific securities being taken off the
trading list for the duration of time) in event of a pre-set, defined by the maximum and minimum fluctuation
in the trading in the secondary market that is the over the counter markets.
Generally the Primary markets are more scrutinized by the same commission but this market comes under
the category of institutional and company related trades and underwritings, as well as guarantees and hence
is governed by the broader set of rules as directed in the corporate and business law and reporting standards
governing the business in the specific geography.

Government bailouts
The US government has provided relief to the ABS industry through Term Asset-Backed Securities Loan
Facility (TALF) during the Great Recession of 2008 and the COVID-19 pandemic.[11][12]

See also
Asset-backed commercial paper
A notes
Asset-based lending
Asset-based loan
Collateralized debt obligation
Credit enhancement
Mortgage-backed security
Pooled investment
Privatization
Securitization transaction
Securities
Structured finance
Term Asset-Backed Securities Loan Facility
Tranche
Thomson Financial League Tables

References
1. assets that otherwise could not be traded has been securitized. MBS and CDO compared:
an empirical analysis (http://mpra.ub.uni-muenchen.de/10381/2/MPRA_paper_10381.pdfAB
S)
2. Vink, Dennis. "ABS, MBS and CDO compared: an empirical analysis" (http://mpra.ub.uni-mu
enchen.de/10381/2/MPRA_paper_10381.pdf) (PDF). August 2007. Munich Personal RePEc
Archive. Retrieved July 13, 2013.
3. "Asset-Backed Security – ABS" (http://www.investopedia.com/terms/a/asset-backedsecurity.
asp). Investopedia. Retrieved July 14, 2013.
4. see also "What are Asset-Backed Securities?" (https://web.archive.org/web/2018062910151
4/http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=16&id=10#sthash.roS
aSia3.dpuf). SIFMA. Archived from the original (http://www.investinginbonds.com/learnmore.
asp?catid=5&subcatid=16&id=10#sthash.roSaSia3.dpuf) on June 29, 2018. Retrieved
July 13, 2013.
5. "Financial Services Alert" Goodwin and Procter, January 18th 2005, Vol. 8 NO. 22
6. "Fixed Income Sectors: Asset-Backed Securities: A primer on asset-backed securities",
Dwight Asset management Company 2005
 7. Tretina, Kat; McGurran, Brianna. "What Are FFELP Loans?" (https://www.forbes.com/adviso
r/student-loans/what-are-ffelp-loans/). Forbes. Retrieved July 26, 2021.
8. Intangible Asset Finance
9. T Sabarwal "Common Structures of Asset-Backed Securities and Their Risks, December 29,
2005
10. Markit (https://www.markit.com/marketing/press_releases.php?date=17Jan2006)
11. "Term Asset-Backed Securities Loan Facility (TALF)" (https://www.federalreserve.gov/regref
orm/reform-talf.htm). www.federalreserve.gov. US Federal Reserve. Retrieved July 17, 2021.
12. "Term Asset-Backed Securities Loan Facility" (https://www.federalreserve.gov/monetarypolic
y/talf.htm). www.federalreserve.gov. US Federal Reserve. Retrieved July 17, 2021.

Further reading
Jason H. P. Kravitt, Securitization of Financial Assets, Second Edition, Aspen Publishers,
New York, New York, 2005.
Steven L. Schwarcz, Structured Finance A Guide to the Fundamentals of Asset
Securitization, November 1990, Second Printing, Practicing Law Institute.
McLean, Bethany (2007). "Asset Backed Securities: The Dangers of Investing in Subprime
Debt", Fortune (https://money.cnn.com/magazines/fortune/fortune_archive/2007/04/02/84034
16/index.htm).
Non-U.S. Asset-Backed Securities: Spread Determinants and Over-Reliance on Credit
Ratings (https://ssrn.com/abstract=1431994), Frank J. Fabozzi, EDHEC Business School,
and Dennis Vink, Nyenrode Business Universiteit (2009). Yale International Center for
Finance working paper.
Stafford, Dan (2018). "Securities-based credit line financing" (http://abnicholas.com/stock-lo
an).
Signoriello, Vincent J. (1991), Commercial Loan Practices and Operations, Chapter 7 Loan
Sales, ISBN 978-1-55520-134-0.
Zweig, Philip L. (2002). "Asset-Backed Securities" (http://www.econlib.org/library/Enc1/Asse
tBackedSecurities.html). In Henderson, David R. (ed.). Concise Encyclopedia of Economics
(1st ed.). Library of Economics and Liberty. OCLC 317650570 (https://www.worldcat.org/ocl
c/317650570), 50016270 (https://www.worldcat.org/oclc/50016270), 163149563 (https://ww
w.worldcat.org/oclc/163149563)
Asset Backed Securities (Frank J. Fabozzi Series)

External links
Leading Investment Bankers in the Asset-Backed Securities Market, according to Asset-
Backed Alert (https://web.archive.org/web/20060207222943/http://abalert.com/data/abalertd
ata/absdata/ABAmarketmakers.pdf)
Asset Backed Securities (http://www.dw.de/asset-backed-securities/av-17911857) Video
produced by DW (Deutsche Welle)
Difference between nonrecourse stock loans and legitimate securities-collateralized lending
(http://www.Abnicholas.com/)

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