As an investor, you probably own mutual funds and have an understanding of how they work. However, you may not have considered how the vast majority of other investments work or how they integrate into various investment portfolios. In this article, we will look at Asset Backed Securities and the function of Securitization.
Asset Back Securities (ABS) and Securitization goes on around us all the time, we just do not really see it first hand, unless of course you work in a large financial institution or the Treasury Department of a large multinational company.
First, let's define Asset Back Securities (ABS):
Let's be clear, the word 'Securities' in this phrase has nothing to do with a uniformed gentleman patrolling the courtyard or car park of an apartment complex or office building to keep away thieves! In this context, Securities are financial products / instruments that people and institutions invest in with the hopes of making a financial gain. The easiest example of Securities is stocks e.g. Volkswagen, IBM, Apple etc... people buy these Securities (stocks) with the hope that the stock price increases and their investment portfolio has positive performance. Bonds are also Securities. People usually buy Bonds in order to generate income for their portfolio. One can also trade Bonds in order to make a financial gain. Thus, Asset Backed Securities, also called ABS for short, are Securities that people / institutions usually invest in to generate income for their portfolio. In fact, Asset Backed Securities are just like Bonds. The income that one receives from ABS is supported (collateralized) by some type of financial asset (receivable / payment), hence the term 'asset backed'. A portfolio that is designed with a stock and bond mix may contain ABS in the bond allocation segment. This may well be achieved through "bond style" mutual funds or by investing with money managers that focus on various debt style offerings that generate income.
So what are the actual assets that support these ABS financial products? Well, it varies throughout the world and with the industry / company that is issuing / sponsoring them. The easiest example is when one buys ABS that are supported by mortgages i.e. mortgage payments / receivables. The assets that back these securities are actual mortgage payments. Think of it like this: When a Bank lends you money to purchase a house, the Bank is taking a risk, but is also generating income for the bank (the interest you are paying on the mortgage is how the bank makes money - the receivable). However, at some point, the Bank has loaned money for thousands of different home purchases for thousands of different people, businesses and families, all of them taking out a mortgage. The Bank has essentially taken on an enormous amount of risk, and cannot really lend any more money... until they "Securitize" (package up these mortgages into tradable financial products called ABSs) and sell them off to investors. The mortgages / loans are pooled together, sold to a Special Purpose Vehicle (an SPV is just an entity really, a bit like an LLC), then the SPV sells the pool to a Trust (another entity), to repackage them again, as income style investments. The Trust usually includes some form of credit enhancement to the pool form a third party to help guarantee payments to the investors. The credit rating of the ABS may end up being better than that of the original Bank (issuer / sponsor). The SPV exists really to isolate the risk. As you may expect, when this process is complete, these ABSs are commonly known as Mortgage Backed Securities. If you feel this ties into the 2008 financial crisis, then you are getting to grips with this subject fast.
When Securitization is done, the Bank can then start lending more money again and start making more profits. It has freed up some capital and removed some risk from its balance sheet. Banks have a certain reserve requirements and if they get close to this threshold, it would be hard to keep lending money. Hence, Securitization happens almost on a daily basis, henceforth keeping the lending ability of the bank (the sponsor / issuer) fluid. Investment banks play a part in this when they actually underwrite the ABSs.
When Securitization is done, the Bank can then start lending more money again and start making more profits. It has freed up some capital and removed some risk from its balance sheet. Banks have a certain reserve requirements and if they get close to this threshold, it would be hard to keep lending money. Hence, Securitization happens almost on a daily basis, henceforth keeping the lending ability of the bank (the sponsor / issuer) fluid. Investment banks play a part in this when they actually underwrite the ABSs.
Auto manufacturers like Porsche, Volkswagen, Ford, Audi, etc... are common issuers / sponsors of Asset Backed Securities. However, instead of mortgages that back the Security, it is car loans and car leases. The reason that companies like Porsche "Securitize" these loans and leases into ABS products is the same reason that the banks do it: To reduce risks and free up more capital and thus improve the balance sheet of the company so that they can go on to do more leases / car loans and make more money. A good looking balance sheet may have a positive effect on the stock price of the company issuing the ABS. If this looks like a cycle, then you are right, because it is!
Credit card receivables, home equity loans and airplane leases are all common income generating ABSs too. As the name implies, airplane leases are issued with respect to the planes that are being leased by large airlines from firms like Boeing or AirBus. Boeing or Airbus has a receivable coming in the door on a regular basis, so they move the financial liability off the balance sheet by going through the process of securitization.
Trading ABS
Trading ABS
Sunguard's Front Arena and MarketAxess are both leaders in electronic trading for the institutional corporate bond market and now offer a dynamic multi-dealer electronic trading platform for consumer-based asset-backed securities (ABS). Beginning with a focus on the most liquid, highest quality ABS issues, MarketAxess has introduced to the ABS market the benefits of greater efficiency delivered on a patented MarketAxess request-for-quote (RFQ) platform.
ABS Trading Platform Highlights include:
- Consumer ABS product types: credit cards, autos, student loans, equipment leases, floor-plans, timeshares, etc.
- Patented bid/offer list trading functionality helps efficiently manage daily cash-flow and sector rotation trades
- Bid/offer list functionality for up to 40 simultaneous line items
- Standard timers create a dynamic and fair auction process
- Spread pricing protocols for uniform dealer responses on bid and offer requests
- Competitive responses via simultaneous access to multiple dealers
- Straight-through-processing for increased speed and efficiency
- Business intelligence reporting
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.
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.
Summary
So we see that ABS and Securitization is all about moving risk off the balance sheet, making the company look appealing to shareholders, and helping investors generate income for their portfolios. As with all types of securities, there are risks involved in trading where you can lose money if the ABS does not 'perform' as expected. Some are riskier than others. Trading ABS is feasible, but it is most definitely geared more towards licensed securities professionals, treasury departments, advisors and hedge fund managers.
So we see that ABS and Securitization is all about moving risk off the balance sheet, making the company look appealing to shareholders, and helping investors generate income for their portfolios. As with all types of securities, there are risks involved in trading where you can lose money if the ABS does not 'perform' as expected. Some are riskier than others. Trading ABS is feasible, but it is most definitely geared more towards licensed securities professionals, treasury departments, advisors and hedge fund managers.
1) Investment Company Institute, 2012
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
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