What are Asset Backed Security (ABS)? How do they work? A simple explanation to understand how to invest in securitized securities issued by banks and where they are traded.
What are Asset Backed Security? How do they work? Below is a simple explanation and guide to finding out where ABS are traded.
ABS bonds are a particular type of bonds issued by operations like securitization. Similar to bonds, Asset Backed Security pay the holder a series of coupons at fixed maturities for a value established on the basis of fixed or variable interest.
To understand how ABS bonds work and the differences with other types of bonds, it is appropriate to first describe the structure of a securitization process.
We will now see in detail how securitization works and why it is important to know it for the purpose of our investment in Asset Backed Security.
Asset Backed Security: what are they?
A Asset Backed Security is a financial instrument guaranteed by several real credits placed in a single financial security.
Credits used as collateral are generally financial or real assets which, taken individually, would not be easily negotiable because they are tangible (so, not liquid).
The operation is similar to that of bonds, in that these instruments also pay a certain amount on fixed dates, at a fixed or variable rate.
Securitization in ABS
Securitization is a financial technique used to transform the credits of a bank (mortgages or consumer loans) into liquid bonds in order to sell them to a special purpose vehicle and subsequently exchange them on the secondary market.
The securitization process can be broken down into three fundamental phases:
- a bank or a financial institution (called the originator) separates a series of credits with uniform characteristics from its balance sheet and forms a portfolio with these;
- the originator’s portfolio is sold to a specially created vehicle company SPV;
- the SPV finances the purchase of credits through the issue of bonds covered by the assets forming part of the acquired portfolio.
The securities issued often obtain a high rating from one of the international agencies thanks to the so-called credit enhancement. This consists of an initiative undertaken by the originator in order to counteract the risk of negative performance of the loans sold and thus reduce the risk of loss, also improving the rating.
Let us take as an example the case of a bank which, in need of liquidity, decides to liquidate the receivables relating to a series of residential mortgages. The bank creates an SPV to which to grant these credits and the guarantees deriving from the mortgage rights relating to the loans.
At this point the SPV issues bonds with a nominal value lower than that of these credits and pays the coupons with the mortgage installments it receives.
Difference between ABS and traditional bonds
The main difference between Asset Backed Security and common bonds is to be found in the fact that the payment of the ABS coupon is strictly linked to the good performance of the credits, both in the interest paid and in the repayment part.
It is here that the main risk of these financial instruments lies since, when there is no total or partial collection of the credits in support of the ABS, the latter would not be repaid in whole or in part. Precisely to mitigate this danger, the amount of the guarantees is often higher than the nominal value of the bonds issued.
The rating in this case will depend on the credit of the issuer, but on the performance that these bonds issued will have.
Asset Backed Security: types
The case of the securitization of mortgages is the most frequent, but other forms of credit are also included in ABS. The most frequent are:
- credits for the purchase of cars;
- mortgages;
- bank credits;
- consumer credits;
- leasing;
- payment flows of credit cards and trade receivables.
However, there are also particular and specialized ABSs which only incorporate bad loans.
Where are ABS traded?
In Europe, ABS are traded on the EuroMOT segment. To protect savers, ABS with the following characteristics are admitted to trading:
- each single issue relating to a securitization transaction must have a residual nominal value of at least 50 million euros;
- they must be instruments disseminated to the public or to institutional investors in order to guarantee the regular functioning of the market;
- must be subject to continuous evaluation by at least one rating agency;
- liquidity must be guaranteed through the intervention of a specialist.
The advantages of ABS for investors
For investors, an advantage of ABS derives from the large amount of credits of which this is formed: there will therefore be a very remote possibility of insolvency of all debtors, which will consequently reduce the overall risk. In addition to this, the saver will achieve greater portfolio diversification. In addition to this, the SPVs that place the products can easily recover part of the investment by selling the assets placed as collateral for the receivables. In addition to this, Asset Backed Security enjoy high ratings.
The advantages of ABS for issuers
For issuers, ABS are a quick way to obtain liquidity. In this way, they are able to finance themselves faster than traditional channels. Securitizations also help financial institutions to improve their balance sheets, as they liquidate part of the receivables recorded in the balance sheet.
The disadvantages of ABS
The main disadvantage of ABS is liquidity, which is lower than that of government issues of equal risk, even if the coupons of the former are usually higher. It follows that the investor may find it difficult to sell its ABS shares on the market. In general, this problem is mitigated by the presence of the so-called specialist, who always guarantees a price for both purchase and sale.
Mortgage Backed Securities: the 2007 subprime mortgage crisis in America
The MBS are mortgage securitisations. This system experienced a true speculative bubble in the past, which when it burst caused the so-called "subrime mortgage crisis". In essence, many individuals with a weak credit history could easily obtain a mortgage by putting the property purchased in this way in mortgage.
These mortgages were then "packaged" in the MBS and sold to the market in order to quickly obtain new liquidity to be able to invest, continuing this vicious circle. When the first subjects were unable to repay the mortgage payments due to the increase in interest rates, there was a cascade effect that led to the bankruptcy of the banking giant Lehman Brothers and a subsequent globalized crisis.
