Asset-Backed Security (ABS) Instrument and Market Features

Prior Learning Modules have shown the funding technique of securitization can be backed by diverse types of assets, including loans and receivables as well as residential or commercial mortgages. A unifying principle in all asset-backed security (ABS) structures is that their underlying cash flows can be reconfigured into various tranches, each with its particular payment pattern to investors and associated risks. T he advantage of this targeted partitioning includes a reduction in the variability of cash flows and the reallocation of risks, such as default and early repayment across specific tranches, with associated returns. Overall, ABS securitization provides risk transfer, flexibility to issuers and investors, and efficiency of capital allocation.

• Covered bonds are issued by financial institutions as senior debt obligations. Backed by a segregated pool of assets typically consisting of commercial or residential mortgages, or public sector assets, these assets remain on the issuer’s balance sheet.
• Non-mortgage ABS are securitizations that remove the pool of assets from the original issuer’s balance sheet. They are generally collateralized by non-amortizing loans, such as credit card receivables, that retain their original loan value during a specific period of their life before the stated maturity date, known as the lockout or revolving period. During this time, principal that is repaid is reinvested to replenish the collateral pool.
• Collateralized debt obligation (CDO) is a generic term describing securitization backed by diversified collateral pools of non-mortgage debt (such as bonds or loans) that redistribute segmented cash flows to investors. The CDO’s tranches receive the cash flows according to an order of priority, with senior claims having lower bond-like payouts and junior claims receiving potentially higher but more variable returns.
• The most common CDO structure is a collateralized loan obligation (CLO) and is subject to uniquely complex non-linear risks in cases of collateral defaults.
• Credit tranching, which involves creating distinct senior and subordinated bond classes (“tranches”), offers credit protection for the more senior bond classes in a securitization. Senior bond classes are paid from the underlying asset pool before subordinated tranches; subordinated bond classes absorb any cash flow losses resulting from defaults in the asset pool before senior tranches.
• Creating a set of bond classes allows investors to choose the level of risk, expected maturity, and the associated returns they prefer. Each bond class created in a securitization is typically rated based on both the quality of the underlying collateral and the seniority of the class.