Credit Crisis - Academics and Analysis - 3

This blog is third in the series of blogs ‘Credit Crisis – Academics and Analysis’. Please read previous blogs first, for a better sense of flow.

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Here I will try to build a basic understanding for another component of ‘Securitized Loans’, which is ‘Asset Backed Securities (ABS)’.

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Asset Backed Securities are similar in structure to Mortgage Backed Securities (MBS), which we discussed earlier. The differences are:

• For MBS, underlying assets are mortgage loans, whereas for ABS, underlying assets are most of other kind of loans. e.g. Credit Card Loans, Auto Loans, Home Equity Loans, Corporate Receivables, Student loans etc.
• Security Issuer is generally a Special Purpose Vehicle (SPV) for ABS, as against govt. or govt. sponsored agencies for MBS.
• ABS securities are generally shorter term securities as compared to MBS securities, so they are less prone to interest rate fluctuations and re-financing. To illustrate, Home Loans are generally for 30 years, whereas say Auto Loan would typically be for 1 to 5 years.
• When MBS is further structured into Tranches, they are known as CMOs. And when ABS is further structured into Classes/Tranches, they are known as CDOs (Collateralized Debt Obligations).

Let’s take an example of Corporate Receivables and see how ABS works for this underlying asset.

• Corporate has some Receivables. It sells them to a SPV and receives a discounted sum.
• SPV securitizes this asset and sells it to end investors.
• During the life of asset, Corporate collects receivables from its customers and pays them to SPV.
• SPV pays them back to Investors.

Motivation for Corporate

• Lower cost of credit to Corporate, as Credit Ratings of SPV are higher than the Corporate itself.
• Working Capital gets freed for further Operational Activities.

Risk Analysis

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Credit Risk to Investors

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To Investors, credit risk is based on Credit Rating of the SPV. Higher the rating, lesser would be the premium charged by investors on that security.

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Credit Risk to SPV

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SPV is exposed to Credit Risk from the Corporate itself. But, there could be Credit Enhancements agreed to by Corporate in the form of Recourse Option and Bankruptcy Remoteness. Recourse Option means, in case of any default on receivables, Corporate would be responsible. And Bankruptcy Remote option keeps these Receivable Assets away from other Creditors, in case Corporate ever files for bankruptcy. Because of such credit enhancements, Credit Ratings of SPV would always be higher than that of the Corporate itself. This reduces the cost of Credit to Corporate.

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Prepayment Risk

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Because underlying Assets in ABS have lower maturity periods (as compared to MBS), time duration of their exposure to Interest Rate fluctuations is lower. This results in lower chances of re-financing by end borrowers and hence a lower Prepayment Risk to ABS investors.

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To summarize, ABS is a structured security which enables individual and institutional investors to provide credit for various consumer and corporate loans.