Updated July 17, 2023
What are Asset Backed Securities?
The term “asset backed securities” refers to securities, mostly bonds, that are backed by collaterals in the form of financial assets, such as credit card receivables, home loans, auto loans, student loans, etc.
Effectively, all these loans are converted into marketable securities through the process of securitization and the repayments of these loans then goes onto to pay the interest to the holders of the asset backed securities.
Explanation of Asset Backed Securities
The primary benefit of asset backed securities is that it generates cash that can be in turn used for more lending, while the investors who put their money in asset backed securities get the opportunity to invest in a wide range of income generating assets. The underlying assets of asset backed securities are usually illiquid in nature and hence the issuers poolthem together to convert the illiquid assets into marketable securities for the investors. That is the main idea behind the creation of asset backed securities.
How are Asset Backed Securities Created?
When the borrowers takeout loans, their liabilities become assets on the lender’s balance sheet. Now the lender can sell these assets to a special purpose vehicle wherein the assets are pooled together and repackaged into newly created asset backed securities that can be sold in the market. The interest and principal payments of the loans made by the borrowers are passed through to the investors who own the asset backed securities. Typically, assets with similar delinquency risks and maturities are clubbed together to create tranches of marketable asset backed securities.
Example of Asset Backed Securities
Let us take the example of a fictitious bank PLM Corp. to explain the concept of asset backed securities. The bank has 500 outstanding residential loans worth average $3 million with a maturity of 10 years and interest rate of 8%. Therefore, the total loan portfolio of the bank is $1.5 billion (= $3 million * 500). The cash flow from the assets is similar to that of a bond wherein the borrower pays the interest annually every year and the principal amount is paid at the time of maturity.
Now, one of the special purpose vehicles (SPV) of the bank purchased the loans from PLM Corp. for $1.5 billion + fees charged by the bank. The annual cash flow from the security for the next 9 years will be $120 million (= 8% * $1.5 billion) and in the 10th year it will be $1.62 billion (= $1.5 billion + $120 million). Now, the SPV will divide the residential mortgage backed securities into 1,000 units worth $1.5 million each with a maturity of 10 years and sell them to the investors. Obviously, the securities will yield a slightly lower return than that of the underlying assets as the SPV will incorporate its own fees for bearing the credit risk.
Types of Asset Backed Securities
The asset backed securities can be mainly divided into three different types based on the type of underlying assets. They are:
- Residential mortgage backed securities
- Commercial mortgage backed securities
- Collateralized debt obligations
Let us have a brief introduction to the different types of asset backed securities.
- Residential mortgage backed securities: In this type of securities, the underlying assets that generate cash flow are residential mortgages. These securities are exposed to both default risk and prepayment risk. However, the default risk is quite low as residential mortgage backed securities are backed by houses as collateral.
- Commercial mortgage backed securities: These type of securities are backed by commercial real estate loans, such as factories, warehouses, hotels, office buildings, apartment complexes, shopping malls, etc. Typically, these securities are very complex owing to the inherent nature of the underlying assets. In the case of commercial mortgage backed securities, the risk of prepayment risk is quite low because of lockout provision and significant prepayment penalties.
- Collateralized Debt Obligations: In these types of securities, the underlying assets include a wide range of assets, such as a residential mortgage, corporate debt, credit card receivables, etc. All types of assets are pooled together and repackaged into discrete tranches on the basis of the riskiness of the underlying assets.
Risks of Asset Backed Securities
The investors of the asset backed securities remain exposed two major risks: credit risk and prepayment risk.
- Credit Risk: It refers to the risk that the issuer of the asset backed securities may default on its payments. The risk of default is usually managed by dividing the entire portfolio into different credit tranches, each tranche with a different level of credit risk exposure. Tranches with higher credit rating indicate a lower risk of default and vice versa.
- Prepayment Risk: It refers to the risk that the borrowers of the underlying assets may prepay their mortgages in a low interest environment, which will impact the regular cash inflow of the investors. The risk of prepayment is usually managed by creating different tranches according to the maturities of the underlying assets resulting in different prepayment risk exposure for each tranche.
Advantages
Some of the major advantages of asset backed securities are as follows:
For Lenders
- The potentially risky loans are taken off from the balance sheet and sold to other investors through securitization.
- By selling these securities, the lenders are able to gain access to a new source of funding that can be used for issuing more loans.
For Investors
- These securities provide interested investors with alternative investment opportunities that can generate higher yields than government bonds.
- It also offers the benefit of portfolio diversification through investment in other markets.
Disadvantages
Some of the major disadvantages of asset backed securities are as follows:
- The prepayment of the underlying assets results in a lower yield for the investors.
- During the economic downturn, these securities may be exposed to widespread defaults.
Conclusion
So, it can be seen that asset backed securities can be advantageous to both issuers and investors. However, their mixed history tainted with instances of the large volume of defaults suggests that the investors should be very cautious before putting their money into these securities.
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