Author: Sabrina Fuchs
An asset-backed security (ABS) is a fixed-income investment instrument that is collateralised by an underlying pool of cash-generating assets. In order to understand this one has to look at the assets from a banking perspective: It is debt and associated interest payments that people or companies owe to a bank, making it an asset for the bank. Typical examples of this are student loans, car leases, mortgages, business loans, or sovereign debt (e.g., a loan taken out by a country or city).
Since some of these assets sit on banks' balance sheets for a very long team, e.g., mortgages for up to 30 years, it is in the banks’ interest to exchange these assets for cash payments, which they can then use to finance new assets. Asset-backed securities enable banks to do exactly that. Banks bundle (“pool”) many, many homogenous loans, e.g., mortgages, together and then sell these to a so-called special purpose vehicle (SPV). The bank then acquires investors and through the SPV the securities are issued. The bank that still receives money paid back by the debtors regularly, e.g., through monthly mortgage repayments and interest, then gives that income as a return on the securities to the investors.
What if the payments are not made anymore and thus no payments come through to the investors? Well, in theory, the underlying assets, e.g., the house the mortgage was paid for, would be sold before the investors would even notice – and for many years that went well. This made it a popular fixed-income investment.
There are multiple advantages an ABS has over a regular bond.
1. While a bond usually only pays coupons annually or semi-annually, most ABS pay monthly.
2. The value of bonds is exposed to changes in interest rates, e.g. if the interest rates have increased a bond bought during times of low-interest rates will not be able to compete against a new bond that was just recently issued with a higher interest rate payoff.
The role of asset-back securities in the financial crisis 2007-09
What happened then? In order to understand that one has to first get an insight into tranching. Tranching is a practice where securities like ABS are divided into tranches that are more or less risky, in order to meet the various risk preferences of different investors. For example, pension funds have very strict rules so that they are solely allowed to invest in safe, well-rated securities. These are known as “senior” tranches, which are considered so safe and well-rated, that they don’t pay off as much as riskier investments. Investors who prefer higher payoffs and can deal with taking the risk of default would then invest in the lower, less well-rated tranches. The idea behind that is that, if someone in the underlying pool of assets defaults, e.g., one student out of 1000 who defaults on his or her student loan, the lowest tranches would then not get their payments anymore, and the higher, more senior tranche owners wouldn’t even notice.
During the financial crisis, however, ABS became so popular, that banks had to keep on creating assets that they could then pool and turn into ABS again. That led to banks giving out loans, mostly mortgages, to people who would have never qualified for such a big loan if it would not be for an ABS. Because ABS gave banks the opportunity to sell off their assets and make a quick amount of money, their incentives to screen and monitor their debtors significantly decreased. Besides, banks were still confident that they could simply sell off the houses in case of bad debt.
But as the real estate bubble of houses continuously gaining value popped, the whole system went with it: More and more people defaulted on their mortgages, leading to more and more banks trying to sell the houses which were used as collaterals, continuously driving down the price of real estate with the sudden increase in supply. As such, asset-backed securities were now backed by assets that significantly lost value. Consequently, banks then rigorously stopped lending since they were not interested in further losing money. That led to businesses running out of ways to raise new funds, people losing their jobs, and even more, people defaulting on their mortgages, car leases, and credit card loans. Together, the loss in value of the assets which were supposed to back the securities and the default of a way higher percentage of debtors than expected led to losses then also being carried by the more senior tranches, leading to losses for pension funds, insurance and private investors who thought they invested their money safely. This led to a quick spread of the crisis from the banking system onto a range of other financial institutions and finally people like you and me.
What has changed about asset-backed securities and how important are they today?
A main problem during the financial crisis was that the asset-backed securities became highly complex and untransparent over time, leading to investors not being able to estimate how safe or not their investments were. The UK Securitisation Regulation now addressed this issue by laying out general standards for all securitisations, and the standards and methods for making them simple, transparent, and standardised (STS) since January 1, 2019. It also requires banks to retain the junior (most risky) tranches of their ABS, so their incentives to keep on monitoring and screening the debtors remain high.
This securitisation legislation attempts to improve the efficiency of the securitisation market. It should ensure that organisations in the financial markets and businesses in the real economy have access to an extensive range of funding opportunities, as well as sufficient investor information. The STS securitisation framework facilitates the comprehension of the risk of a securitised transaction for investors, as well as its risk management.
Asset-backed securities have established themselves as an integral part of the international financial sector. The bond market's disparities are the main reason for the success of the higher-yielding and – in normal times - more stable ABS.