What Are Asset-Backed Securities?
Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans,¹ such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans. ABS differ from most other kinds of bonds in that their creditworthiness (which is at the triple-A level for more than 90% of outstanding issues) derives from sources other than the paying ability of the originator of the underlying assets.
Financial institutions that originate loans—including banks, credit card providers, auto finance companies and consumer finance companies—turn their loans into marketable securities through a process known as securitization. The loan originators are commonly referred to as the issuers of ABS, but in fact they are the sponsors, not the direct issuers, of these securities.
These financial institutions sell pools of loans to a special-purpose vehicle (SPV), whose sole function is to buy such assets in order to securitize them.² The SPV, which is usually a corporation, then sells them to a trust. The trust repackages the loans as interest-bearing securities and actually issues them. The “true sale” of the loans by the sponsor to the SPV provides “bankruptcy remoteness,” insulating the trust from the sponsor. The securities, which are sold to investors by the investment banks that underwrite them, are “credit-enhanced” with one or more forms of extra protection—whether internal, external or both.
ABS constitute a relatively new but fast-growing segment of the debt market. The first ABS were issued in 1985; in that year, the market for publicly offered ABS issues was $1.2 billion. In 2003, issuance totaled a new record of $479.4 billion. This booklet primarily addresses publicly issued ABS, although the growing private-issue ABS market is briefly mentioned. It is estimated that a total of over $2.6 trillion of ABS were issued from 1985 through 2003.
¹ Securities backed by first mortgages, although the most common ABS, are considered a separate investment category and are therefore not included in this guide. They are discussed in detail in the Securities Industry and Financial Markets Association Investor’s Guide to Mortgage Securities.
² Certain types of financial institutions, such as banks, may sell their loans directly to a trust that issues ABS, since the intermediate sale to an SPV is not needed to achieve bankruptcy remoteness.
Investors in ABS are typically concerned about the likelihood and extent of prepayment. That is, they worry about receiving all or part of the principal of the underlying debt before it is due (in the case of amortizing assets) or before it is expected (in the case of nonamortizing assets). Determining the most likely prepayment scenario is critical to making an investment decision with a reasonable expectation about a security’s life—which, in turn, affects the likely yield.
What follows are explanations of the key prepayment conventions used by the ABS market. Investors should bear in mind that prepayment models do not predict actual prepayment behavior, but instead provide a common methodology for expressing prepayment activity. Moreover, since the ABS market has existed only since the mid-1980s, prepayment models, which are based on historical performance, are likely to evolve further.
Constant Prepayment Rate Prepayment Model
Also known as conditional prepayment rate, the CPR measures prepayments as a percentage of the current outstanding loan balance. It is always expressed as a compound annual rate—a 10% CPR means that 10% of the pool’s current loan balance pool is likely to prepay over the next year. The CPR is commonly used to describe the prepayment experience of HELs and student-loan assets.
Monthly Payment Rate Model
Technically, this is not a prepayment measure, because it is used with nonamortizing assets, such as credit card and dealer floor-plan receivables, which are not subject to prepayment. Rather, the MPR is a repayment measure and is calculated by dividing the sum of the interest and principal payments received in a month by the outstanding balance. The rating agencies require every nonamortizing ABS issue to establish a minimum MPR as an early-amortization trigger event; if repayments drop to that level, the security enters into early amortization.
Absolute Prepayment Speed Prepayment Model
This abbreviation (which, confusingly, is the same as that used for asset-backed securities) is commonly applied to securities backed by auto loans, truck loans, RV loans and auto leases. Unlike CPR, which measures prepayments as a percentage of the current outstanding loan balance, the ABS calculates them as a monthly percentage of the original loan balance.
Home-Equity Prepayment Curve (HEP)
The HEP curve is a prepayment scale (ranging from 0% to 100%) for HELs that captures the more rapid plateau for home-equity prepayments vis-a-vis that of traditional mortgages. It is a 10-month seasoning ramp with even step-ups, terminating at the final HEP percentage in the 10th month. The standard HEP is 20%; it equals 2% CPR in the first month, 4% in the second month, 6% in the third month and so on until it levels off at 20% CPR in the 10th month.
Controlled Amortization ABS Structure
Revolving debt (primarily credit card receivables, but also HELOCs, trade receivables, dealer floor-plan loans and some leases) may be securitized using a controlled amortization structure. This is a method of providing investors with a relatively predictable repayment schedule, even though the underlying assets are nonamortizing. Controlled-amortization ABS resemble corporate bonds with a sinking fund. After a predetermined “revolving” period during which only interest payments are made, these securities attempt to return principal to investors in a series of defined periodic payments that usually occur over less than a year. A risk inherent in this kind of ABS is an early amortization event. (See “Early-Amortization Risk,” on page 20.)
Fully Amortizing ABS Structure
Securities that return principal to investors throughout the life of the security are said to be fully amortizing. They are designed to closely reflect the full repayment of the underlying loans through scheduled interest and principal payments. They are typically backed by HELs, auto loans, manufactured-housing contracts and other fully amortizing assets. Prepayment risk is a key consideration with such ABS, although the rate of prepayment may vary considerably by the type of underlying asset.
Soft/Hard Bullet ABS Structure
“Bullet” structures, which are also used with revolving assets, are designed to return principal to investors in a single payment. These ABS also feature two separate cash-flow management periods: the revolving period, during which any principal repaid is used to buy more receivables, and the accumulation period (analogous to the amortization period in a controlled-amortization structure), during which principal payments build up in an escrow account to fund the bullet payment to investors.
The most common bullet structure is the soft bullet, so labeled because the bullet payment is not guaranteed on the expected maturity date (although most such ABS do pay off on time). The potential for a shortfall exists during the accumulation period, in which case investors may receive the remaining principal payments over an additional period (usually one to three years) until what is known as the final maturity date.
In contrast, a hard-bullet structure ensures that the principal is paid on the expected maturity date and does this with a longer accumulation period, a third-party guarantee or both. In a hard bullet, rating agencies evaluate the timeliness of principal payments. Hard bullets are rare, because investors are comfortable with soft bullets and are unwilling to pay extra (in the form of a lower yield) for a guarantee. As with controlled-amortization structures, soft- or hard-bullet structures are also subject to early amortization risk.
Floaters ABS Structure
Issues—backed both by amortizing assets (notably auto loans) and nonamortizing assets (credit cards)—have had a floating, rather than a fixed, interest rate. The rate adjusts periodically according to a designated index (such as LIBOR or, in some cases, U.S. Treasury bills) plus a fixed margin.
When the underlying collateral is itself made up of floating-rate loans—such as credit card debt indexed to the prime rate—a floating-rate coupon on the ABS can help avoid a cash-flow mismatch between the borrowers and the investors. When the collateral consists of fixed-rate loans, a cash-flow mismatch is inevitable. Therefore, the issuing trust often arranges with a counterparty for an interest rate swap or with an outside provider for a rate cap to offset the resulting basis risk to investors.
Sequential Pay ABS Structure
Sequential-pay securitie means that the first tranche (the one with the shortest average life) receives all available principal payments until it is retired; only then does the second tranche begin to receive principal; and so on. (The alternative structure is pro rata pay, under which all tranches receive their proportionate shares of principal payments during the life of the securities. A combination of these is also very common: sequential deals that switch to pro rata at a certain date or pro rata deals that switch to sequential upon credit-related events.)
As stated above, one of the main ways ABS are credit-enhanced is with a senior/subordinated structure, in which a senior class of securities is supported by one or more tranches of subordinated securities. The order in which investors in the subordinated ABS are paid is determined by the payment rights and priorities that are established when the junior classes are issued.