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Asset-Backed Securities

News

"Americans are walking, even running, away from financial obligations ranging from car loans and mortgages to credit-card payments at a record rate. Debt loads, and bankruptcies, are soaring. But demand for the bonds that offer investors a flow of cash linked to repayments on those debts has hit a high, propelling prices of these securities to record levels.

In the second week of June alone, nearly $6 billion of asset-backed securities, as they're known, were sold by underwriters to yield-hungry investors." (WSJ, June 17, 1996)

Analysis

What are asset-backed Securities?

They are fixed-income securities, or IOUs, that are backed by cash-generating assets as collateral. The collateral comes in different types such as credit-card receivables, car-loan payments, home equity loan cash flows, leasing payments or other less mainstream sources of cash. Some are backed by mortgages, and thus are referred to as mortgage-backed securities (MBS).

Who Issues Them and Why?

The sources of assets are leasing companies, commercial banks, savings & loans, and other financing institutions. These companies sell them to underwriters who re-structure the pool of loans and sell them to investors.

By selling the original loans to underwriters, the lending institutions do not have to absorb the risk of potential delinquencies, and at the same time immediately receive the present value of the associated future cash flows. With more cash on hand, the lending institutions have more immediate money to lend to potential borrowers. Thus, selling them, or getting them of their books as it is sometimes referred to, reduces risk and provides a source of immediate cash for further lending.

How Is Their Risk Measured?

Just like any public debt, the rating agencies, such as Moody’s and Standard & Poor’s, publish rankings according to their default potential.

Nevertheless, these assets can be very risky as there are two, not necessarily related, sources of risk. The first source is interest rate risk, in that the value of the assets fluctuates inversely with changes in the general interest rate levels. However, an additional source of risk is the unpredictability of defaults on loans that are the collateral for the debt. Despite a healthy economy and relatively low interest rates, defaults on both personal and mortgage loans are currently running at extremely high levels. Thus, the value of asset-backed securities can be very volatile, especially in response to changes in interest rates.

Why Do Investors Buy Them?

There are two classes of buyers: speculators and investors. The former group can use them for speculation on the direction of interest rates or default rates. Because of their high sensitivity to changes in yield rates, a speculator who believes that interest rates or default rates are going down would buy them. Obviously, if she is correct in her guess about the direction of interest rates or default rates, she can make a handsome profit.

An investor, on the other hand, would hold such assets as they provide a unique risk-reward pattern that might, say, add further diversification if included in the investor’s portfolio.

By Alex Tajirian