Introduction to Asset-Backed Securities

Introduction

Previous readings examined the risk characteristics of various fixed-income instruments and the relationships between maturity, coupon, and interest rate changes. This reading introduces fixed-income instruments created through a process known as securitization. The securitization process transfers ownership of assets such as loans or receivables from the original owners into a special legal entity. The special legal entity then issues securities, using the asset cash flows to pay interest and repay the principal to investors. These securities are referred to generically as asset-backed securities (ABS), and the pool of assets from which their cash flows are generated is called collateral or securitized assets. These loans and receivables typically include residential mortgage loans (mortgages), commercial mortgages, automobile (auto) loans, student loans, bank loans, accounts receivable, or credit card receivables. While the ABS market in the United States remains the largest in the world, securitization has recently expanded in both Asia and Europe as well as to other income-yielding assets, such as airport landing slots, toll roads, and cell tower leases. The growing depth and breadth of the global ABS market underscores the importance of a solid understanding of securitization among issuers, investors, and financial analysts. 

This reading describes the securitization process, discusses its benefits for both issuers and investors, and explains the investment characteristics of different types of ABS. Although investors can invest in some loan types via private credit funds or through secondary markets, securitization creates a more direct link between investors and borrowers for many types of loans and receivables. The terminology regarding ABS varies by jurisdiction. Mortgage-backed securities (MBS) are ABS backed by a pool of mortgages, and a distinction is sometimes made between MBS and ABS backed by non-mortgage assets. This distinction is common in the United States, for example, where typically the term “mortgage-backed securities” refers to securities backed by high-quality real estate mortgages and the term “asset-backed securities” refers to securities backed by other types of assets. Covered bonds date back to 18th century Europe and are similar to ABS, but they offer investors recourse to both the issuing financial institution and an underlying asset pool.

To underline the importance of securitization from a macroeconomic perspective, we discuss the benefits of securitization for economies and financial markets. Then, we describe the structure of a securitization, identifying the parties involved and their roles as well as typical structures. We further discuss securities backed by mortgages for real estate property, including residential MBS and commercial MBS, and review two common types of non-mortgage ABS—namely, those for auto loans and credit card receivables. The reading concludes with a description of collateralized debt obligations and covered bonds.

Benefits of Securitization for Economies and Financial Markets

The securitization of pools of loans and receivables into multiple securities provides economies and financial markets with several benefits.

Home or auto purchases have been traditionally financed by loans originated by financial institutions, such as commercial banks. For investors to gain exposure to these relatively illiquid loans, they must hold some combination of deposits, debt, or common equity issued by banks. This situation creates an additional intermediary (that is, the bank) between the borrowers and the investors. In addition, by being constrained to hold bank deposits and securities, investors cannot gain direct exposure to loans but are also affected by economic risks undertaken in other bank activities.

Securitization solves a number of these problems. It allows investors to achieve more direct legal claims on loan and receivables portfolios, enabling them to tailor interest rate and credit risk exposures to suit their specific needs. Disintermediation (that is, lessening the role of intermediaries) can effectively reduce borrower costs and enhance risk-adjusted investor returns. At the same time, banks can separate loan origination from financing, improving their profitability via origination fees and reducing capital requirements for loans that are sold. Securitization enables banks to expand lending origination beyond their balance sheets, ultimately benefiting individuals, governments, and companies that need to borrow.

Securitization also benefits investors by creating access to securities with profiles that match their risk, return, and maturity needs that are otherwise not directly available. For example, a pension fund with a long-term horizon can gain access to long-term real estate loans by investing in residential MBS without having to invest in bank bonds or stocks. Although few institutional or individual investors are willing to make or purchase real estate loans, auto loans, or credit card receivables directly, they may invest in a security backed by such loans or receivables. The ABS that are created by pooling these loans and receivables have characteristics similar to those of a standard bond and do not require the specialized resources and expertise needed to originate, monitor, and collect the payments from the underlying loans and receivables. As a result, investors can increase exposure to the risk–return characteristics of a wider range of underlying assets. Note that in many countries, the sale of ABS and similar instruments is restricted to investors who meet certain qualifications, such as those pertaining to net worth.

Securitization allows for the creation of tradable securities with better liquidity than that of the original loans on the bank’s balance sheet. In making loans and receivables tradable, securitization makes financial markets more efficient. It also improves liquidity, which reduces liquidity risk in the financial system, as described later.

An important benefit of securitization for companies is that ABS provide an alternative means of funding operations that can be considered alongside bond, preferred equity, and common equity issuance. Companies that originate loans and receivables that can be securitized often compare and optimize the funding costs associated with each source of financing. As we will see, securitization is often less costly than a corporate bond issue secured by the same collateral.

For these reasons, securitization is beneficial to economies and financial markets and has been embraced by many sovereign governments. For example, the Italian government has used securitization since the late 1990s for privatizing public assets. In emerging markets, securitization is widely used. For example, in South America, companies and banks with high credit ratings have used securitization to sell receivables on exports, such as oil, to lower their funding costs.

Although securitization brings many benefits to economies, it is not without risks, and some of these risks are widely attributed to have precipitated the turmoil in financial markets during 2007–2009. Broadly, those risks fall into two categories: risks that relate primarily to the timing of the ABS’s cash flows, such as contraction risk and extension risk, and risks related to the inherent credit risk of the loans and receivables backing the ABS. This reading describes these risks and discusses some of the structures used to mitigate them as well as redistribute them.

The member should be able to:

• explain benefits of securitization for economies and financial markets;
• describe securitization, including the parties involved in the process and the roles they play;
• describe typical structures of securitizations, including credit tranching and time tranching;
• describe types and characteristics of residential mortgage loans that are typically securitized;
• describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and
• risks for each type;
• define prepayment risk and describe the prepayment risk of mortgage-backed securities;
• describe characteristics and risks of commercial mortgage-backed securities;
• describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and risks of each type;
• describe collateralized debt obligations, including their cash flows and risks;
• describe characteristics and risks of covered bonds and how they differ from other asset-backed securities.