Let’s face it, Americans like their ‘stuff’. A nice house, luxury car, vacations and private school education is what many aspire to obtain. But these typically come at a cost- lots of debt. But all this debt does have a silver lining. Its interest provides a much-needed income stream for investors, especially in today’s low-interest rate environment. This is the realm of yet another alternative investment, asset backed securities.
What are Asset Backed Securities?
Asset backed securities (ABS) are financial securities whose income comes from a pool of underlying assets. Examples of these underlying assets include student loans, auto loans, credit card balances, structured settlement payments, even movie revenues and mobile home loans. Essentially, any future income stream, no matter how illiquid or infrequent, can be turned into an investable “asset”. Noticeably absent from the list are mortgage loans because they are a separate class of securities known as mortgage backed securities or MBS. Here’s how it works.
This is a (very) simplified example of how an auto loan ABS gets created. Loan originators (typically a bank or consumer financial company) makes an auto loan to a customer. Then another, and another. At a certain point, the institution feels it has enough risk (of repayment by the borrowers) on its books. It has a couple options. It can 1-make no more loans and simply wait for the interest payments to come in or 2- it uses an entity known as a special purpose vehicle (often a trust) to bundle these outstanding loans and sell them to investors.1 In the second option, the interest payments now get made to the trust who allocate them to the investors, not the originating the bank.
Why Securitize Debt?
The securitization process provides a few advantages for the financial institution. First, it takes the loans, and the default risk, off of their books (passing it on to investors). This could improve their credit rating, leading to cheaper costs of capital. Also, the sale of these loans provides an infusion of cash flow, with which they can use to make further loans, and the lending cycle begins again.
An ABS offering gets sold to investors via an offering by underwriters. These underwriters are often a syndicate of investment banks. ABS deals can be rather complex, with a variety of classes or tranches for investors.
One tranche might be full of the highest rated loans and offer investors a modest interest rate. Other tranches, such as mezzanine and equity, could be full of riskier high yield and subprime debt. These lower-rated tranches are subordinate to the senior tranche meaning the senior tranche won’t sustain any losses (as a result of credit or prepayment risks) until the junior tranches have losses up to their full value. Investors in these riskier tranches will enjoy an increase in interest income for a commensurate increase in risk.
Chinese Asset Backed Securities
The way the financial industry (and debt) has boomed in China in recent years, it’s not surprising that there is an asset backed securities industry there.
The Chinese ABS industry began in 2005 and was actually suspended by Chinese regulators in 2009, following the financial crisis in the United States, caused partially by mortgage backed securities.2
But they are back with a vengeance. Ironically, one of the reasons for this renewed acceptance is actually to reduce risk in their financial system since putting Chinese debt on the books keeps it away from the hidden corners of the shadow banking system. Chinese ABS is an area we will definitely be keeping an eye on in the future.
Size of the ABS Market
Here in the United States, the issuance of asset backed securities has also flourished since the Great Recession, especially in recent years. In 2014, ABS issuance was a record $328.9 billion, surpassing the pre-crisis peak of $290 billion of 2007.3 2015’s issuance tapered somewhat, but still came in at a robust $274.5 billion.4
There were over $1.39 trillion in total asset backed securities outstanding as of the end of 2015, the largest since 2010.5 As long as there is demand for credit coupled with low interest rates, the ABS market should continue to flourish.
Institutional investors such as central banks, insurance companies, corporate bond funds, pension funds and endowments are the primary purchasers of asset backed securities. But individual investors can also invest. They might consider an ABS index, to reduce the security specific risk (let the institutional investors pick the specific ABS).
ABS Financial Career Options
If working on asset backed security deals sounds interesting, you are in luck. A search for the term ‘asset backed securities’ on LinkedIn jobs, revealed over 3800 related openings from well-known companies including BlackRock, Guggenheim Partners, and Ocwen Financial.6 The positions are typically for analysts to help work on the deals for the investment bankers. ABS are offered to the public through the investment banking division of a financial institution. Analyst can be a catch-all term, and any candidates should be ready to get up close and personal with a spreadsheet.
Buy-side analysts will be tasked with valuing these securities for portfolio inclusion. Sure, rating agencies will issue a credit rating on many ABS, but after the debacle of mortgage-backed securities a decade ago, many buy-side analysts prefer to value these securities themselves. Remember that many of the collateralized debt obligations almost blew up the financial system and were ‘AAA-rated’ by rating agencies.
But trying to value a group of complex securities is quite a challenge. It’s nearly impossible to conduct fundamental credit analysis on each individual debt obligation. Analysts must apply the appropriate spread to the ABS to obtain a relative valuation.
Some asset backed securities have embedded options. These are additional features of the loans that can alter the steadiness of the cash flows, such as pre-payments. The largest category of asset backed securities, home equity loans, have such pre-payment risk.7 If the ABS has these embedded options, analysts apply the option adjusted spread, or OAS, to value the security. The OAS is the spread that accounts for these options and is often found using Monte Carlo simulation, especially with interest rate sensitive ABS such as home equity loans.8
On the other hand, if there are no embedded options, such as with credit card receivables, analysts will use the zero-volatility spread. This ‘z-spread’ is the constant spread that makes the price of a security equal to the present value of its cash flows when added to each Treasury spot rate.9 These types of advanced bond analyses are covered in the Chartered Financial Analyst, CFA, program (typically Level II) and will be covered in some Masters in Finance programs.