Types of Assets That Back Securities

Theoretically, any asset that has a revenue stream can be transformed into a marketable debt security. In practical terms, the vast majority of ABS are collateralized by loans and other financial assets.

The first four asset types listed below—home-equity loans, auto loans, credit cards and student loans—together constitute the largest segment of the ABS market. Historically, they have been securitized for the longest period and together account for over 80% of total public nonmortgage ABS issuance to date.

There are various ways to classify securitized assets, but perhaps the key distinction for investors is whether the assets are amortizing or nonamortizing, because this affects the cash flows investors receive. An amortizing loan is one that must be paid off over a specified period with regular payments of both principal and interest. A nonamortizing, or revolving, loan does not require principal payments on a schedule, so long as interest is paid regularly. Revolving credit card accounts are perhaps the leading example of nonamortizing loans.

These loans now constitute the largest sector of the ABS market. Forty-four percent of the ABS issued in 2003 were backed by closed-end home-equity loans (HELs) and open-end loans, which are also called home- equity lines of credit (HELOCs). Both types of loans enable homeowners to borrow against the nonmortgaged value of their homes, and often use these loans to consolidate all their debt into one monthly payment. The interest on HELs is generally tax deductible.

A closed-end loan may be a second mortgage on a property or, increasingly, a first mortgage. HELs have a fixed term, typically from 10 to 30 years. Generally, borrowers who take out HELs as their first mortgage are known as B or C borrowers; they are people with impaired credit. As mortgages, HELs are amortizing assets.

HELOCs, in contrast, provide a revolving credit line against which homeowners may borrow as they wish for a number of years. They are similar to credit card receivables and are generally considered nonamortizing assets (although some are partially amortizing because they require small, regular principal payments).

The second largest, and the oldest, asset class in the ABS market is auto loans (16.1% of issuance in the first half of 2003). Most auto ABS are supported by prime loans—those made to borrowers with very strong credit histories. But some auto ABS are collateralized by loans to subprime (also called B, C and D) borrowers. Loans to individual car buyers are amortizing assets.

Securities collateralized by credit card receivables are one of the oldest segments of the ABS market, representing 14.3% of ABS issuance in 2003. Holders of credit cards may borrow funds, generally on an unsecured basis up to an assigned limit, and pay the principal and interest as they wish, as long as they make a small required minimum payment on a regular basis—generally once a month. Consumers may also borrow more money while paying off the old debt, if they do not exceed the credit limit. Because cardholders do not have to pay off the principal on a schedule, credit card debt has no actual maturity and is therefore a classic example of a nonamortizing loan.

Student loan ABS represented 8.1% of ABS issuance in 2003. As a group, student borrowers have relatively high default rates, but this reality is largely neutralized by government guarantee programs that cover most student loans. However, a small but growing number of student loans do not benefit from government guarantee programs; lenders therefore bear the risk on such loans directly. Student loans are amortizing assets; that is, they must be paid off according to a predetermined schedule.

Another comparatively small portion of the ABS market (1.5% of issuance in 2003) is represented by securitizations of leases for computers, telephone systems and other kinds of business equipment. Leases take two forms—closed end and open end, the difference being how the equipment (or its “residual value”) is paid for at the end of the lease. Both types of leases are amortizing assets. Equipment lessees are usually corporations, rather than individuals, and have good credit profiles.

There are several other emerging asset classes, including auto leases, small-business loans, short-term auto dealer inventory loans (or dealer floor-plan loans) and trade receivables (particularly hospital receivables). Beyond these are some even more embryonic asset classes. One new class that has made news is royalties payable to rock stars from a specified pool of their works.

Collateralized bond obligations (CBOs) and collateralized loan obligations (CLOs) are a fast growing new sector of the private asset-backed securities market. “CBO” or “CLO” generally refers to a debt obligation whose underlying collateral and source of payment consists of existing bank loans, emerging-market, high-yield or other forms of debt obligations.

Issuers and investment banks will continue to search for—and find—new types of assets to securitize to meet the growing investor demand for ABS.