Asset-Backed Security

Explained:

An asset-backed security (ABS) is a securitized interest in a pool of assets. Conceptually, the structure is similar to a mortgage-backed security (MBS), so it is convenient to describe the structure according to its differences from MBS.

MBSs are backed by mortgages—fixed rate, floating rate, residential, commercial, single family, multi-family, etc. ABSs are backed by non-mortgage assets. This includes auto loans, credit card receivables, home equity loans, student loans, etc. Due to government guarantees, MBSs typically entail no credit risk. ABSs generally lack such guarantees, so they entail credit risk. Due to diversification of the underlying assets, as well as credit enhancements, that risk tends to be modest. ABSs can be subject to prepayment risk, but this is slight compared to that of MBSs. Consumers are more likely to refinance a home than an auto in response to a drop in interest rates.

ABSs are appealing to issuers because the structure allows them to get assets off their balance sheets, freeing up capital for further receivables. Also, ABSs make it possible for issuers whose unsecured debt is below investment grade to sell investment grade—even AAA-rated—debt.

To create an ABS, a corporation creates a special purpose vehicle to which it sells the assets. While is is common to speak of the corporation as the issuer of the ABS, legally, it is the trust or special purpose vehicle that is the issuer. It sells securities to investors. To protect investors from possible bankruptcy of the corporation, there are three legal safeguards:

Transfer of assets from the corporation is a non-recourse, true sale.

Investors receive a perfected interest in the assets' cash flows.

A non-consolidation legal opinion is obtained certifying that assets of the trust or special purpose vehicle cannot be consolidated with the corporation's assets in the event of bankruptcy.

These same safeguards allow the corporation to remove the assets from its balance sheet. The corporation generally continues to service the assets—collecting interest and principal payments, pursuing delinquencies, etc. It is paid out of asset cash flows for providing these ongoing services.

For investors, ABSs are an alternative to highly-rated corporate debt. They generally offer similar or superior liquidity. Because the underlying assets are diversified, they are less subject to credit surprises.

ABSs can be structured into different classes or tranches, much like collateralized mortgage obligations (CMOs). There may be senior or subordinated classes of debt, which have different credit ratings. Tranches may be structured with different average maturities. Choice of structure depends upon investor demand as well as the nature of the underlying assets.