Any financial security if at all backed by a loan, lease or receivable against assets other than real estate and mortgage backed securities can be defined as an ‘Asset Backed Security’.
Let us analyze the definition for a better understanding.
A financial security is a contract between the issuer (of security) to the investor (who lends money) in accordance with some pre-agreed guidelines. If this security is backed by loan or lease or receivables (other than real estate and mortgage backed) then that security is an ‘Asset Backed Security’. ABS are opportunities for the financial institutions/organizations to increase their liquidity ratio, best usage of the capital they have and helps in generating fee based income.
The Asset backed Securities have been used by most of the banks to raise wholesale money from the market. Before the credit crunch, it was a convenient way to raise money from the market and subsequently use it for rolling out more new products.
Securitization is a structured finance process that is carried out to reduce and mitigate the risk of wide variety of assets and corporate products. The process involves repackaging of wide number of low value high risk assets into a securitized product with low risk profile and high value.
Securitization of a wide variety of assets and products is done due to inherent benefits provided by the repackaging of cash-flow producing financial assets into securities that can be sold to investors. It allows the bank to offload a variety of high risk low value products off its balance sheet and reduce further risk.
How Banks Sell Asset Backed Securities:
These are sold through specialized Asset Backed Commercial paper conduits or Special Purpose Vehicle’s (SPV’s). The selling banks sell a pool of Assets to a Special Purpose Vehicle (SPV). The SPV in order to fund the purchase issues mortgage or Asset backed securities which are sold to investors in capital markets.
This transfers the risk of these securities from the Bank to the buyers of Asset backed securities.
The following is the list of Assets which are normally securitized by banks: Mortgages, Vehicle loans, Real Estate loans, corporate loans etc.
How banks buy Asset Backed Securities:
The issuing party (SPV’s created by banks) raise funds by promising to repay a lender in accordance with terms of a contract. So the banks buy ABS (Asset Backed Securities) through these SPV’s.
Types of debt instruments used for ABS (Asset Backed securities) include notes, bonds, certificates, mortgages, leases or other agreements between a lender and a borrower. Most bonds backed by mortgages are classified as an MBS (Mortgage backed securities).
Factors used to determine the price of Asset Backed securities are provided below:
Rating provided by various rating agencies: The ABS with high risk profile gives high rate of interest and the one with low risk gives offers less interest rate. The rating agency decides the rating of ABS based on the following factors:
Collateral Credit Quality: It is the most important factor for rating an ABS. The agency evaluates whether the collateral is of sufficient quality to be able to provide cash flows to pay the principal plus the interest.
Seller/ servicer Quality: The rating agency looks at the servicer’s performance, history, experience, underwriting standards adopted for loan origination, servicing capabilities and financial strength.
Cash flow stress and payment structure: Rating agency analyzes ABS cash flow projections under different scenarios to the various tranches (bond types).
Legal structure of the bank and the SPV (special purpose vehicle) floated by the bank: The Banks float SPV’s to separate securitized products from their balance sheet. The rating agencies analyze the structure of securitized assets so that even in case of bankruptcy of issuing bank, the SPV of the bank remains safe and free of any liabilities/ responsibilities.
Market Data Sources: Traders and money managers use market data sources e.g. Bloomberg, BankScope and Intex to analyze and correctly price Mortgage backed security pools. This data includes the following details:
This data is downloaded daily/ weekly from these websites and fed in a database used for analysis.