What are Asset-Backed Securities and Mortgage-Backed Securities?
As the market deepens, various indices are created about the functioning and rate of change in the assets which are also useful for determining value of a derivative instrument, which are of 2 types, asset-backed securities index(ABS) which shows the market performance of ABS Market which is calculated as the weighted average of a portfolio of ABS while Mortgaged backed securities (MBS) index shows the MBS market movement as the weighted average of bonds and promissory notes backed by only property mortgages.
As markets deepen, indices are developed to get a sense of how the market is performing. They are also used as the base for derivatives which are instruments that take their value from the movement of the indices.
Can institutions use the loans and receivables that they have in their portfolio to generate more cash for further lending? The answer is yes, they can pool receivables, be it loans or the credit that they have extended, which have similar tenure and risk profile and sell it to investors. These pools are typically in the form of a bond or promissory note. These securities are called Asset-Backed Securities (ABS). The investor in these securities owns a part of the loan or receivable. This allows the institution to turn its illiquid assets into ready cash to use in their business.
The typical assets which are securitized into Asset-Backed Securities (ABS) are credit card receivables, leases, company receivables, royalties, etc. Mortgage-Backed Securities (MBS) are a subset of ABS and are backed by mortgages on residential properties i.e. home loans. MBS is a subset of the ABS are they contain a specific type of asset.
Also, look at Bond Pricing for your better understanding of this article.
What is Securitization?
The process of turning illiquid assets that have future cashflow into ready cash-generating financial securities by pooling together assets of a similar type, tenure and risk profile is called Securitization. This is usually done by a separate entity that buys the future cash flow generating assets from the original company at a discount and then pools them to sell to investors. Theoretically, any asset which has future cashflow can be securitized.
Creation of Asset-Backed Securities
For example, a Company ABC Ltd. which is a leasing company has monthly receivables from its customers. These receivables are in the future so the company cannot use them today to make further loans, so it is selling all the receivables to another entity, company SPV, which pays it a present value for these future cash flows. This allows the ABC Company to convert these future inflows into cash today and use it in its business. Company SPV now packages these leases into different pools called tranches, based on their maturity and quality of the lessee and sells it as bonds or promissory notes to investors. Since these bonds are backed by specific assets they are called asset-backed securities. The way the repayment would work is that the lessee would make a periodic lease payment to Company ABC which in turn would pass it on to Company SPV as they now own the lease which would then use this money to make the coupon payments to the investors.
The portfolio of cash flows from the originating company is pooled according to their maturity and risk profile to sell to investors. Each tranche consists of cash flows with similar timing and risks. This is done so that the investor can choose according to his risk appetite, the appropriate tranche to invest in.
As the Asset-Backed securities are in the form of bonds/ promissory notes they are exchange-traded so they give the investors the flexibility to sell, them hence providing liquidity as and when required. The process of securitizations converts an illiquid loan in the hands of the originating company into a liquid, tradable asset in the hands of the investor.
These bonds which are exchange-traded now give the investors liquidity to buy and sell them. The interest rate prevalent in the market and the risk profile of the asset-backed bonds determines the price of these bonds.
What is the ABS Index?
An ABS index is a method of measuring the value of the ABS market. It is a weighted average value of a portfolio of the Asset-backed securities. Different indices use different ABS in varying proportions as weights to determine the value of the index. Hence an ABS Index is “Weighted average value of various ABS bonds/ promissory notes traded in the market”.
An MBS Index is a kind of ABS index that takes the weighted average value of bonds/ promissory notes which are backed only by property mortgages.
The major risk that ABS bonds face is the interest rate and prepayment risk. Interest rate risk is what the entire market faces with regard to market-wide. Many people rather than investing in any single ABS bond, prefer to invest in a portfolio to mitigate their price risk. Any instrument like an exchange-traded fund (ETF) which mirrors the ABS index would offer such an investment avenue.
Types of ABS Indices
ABS Indices are of different types, with some specialized indices comprising of bonds with assets as auto loans or credit cards or mortgages only, while there are other broad-based ABS indices that have bonds backed by assets of all types.
In the US, the Asset-Backed Securities were first introduced in the 1980s and hence the market is mature and deep enough to have numerous ABS indices. These indices are designed by financial institutions like investment banks as a product for their clients.
ABS Indices in the US
Examples of a few of these indices in the US are:
#1 – Barclays U.S. Floating-Rate Asset-Backed Securities (ABS) Index:
This index includes Asset-Backed Securities of one year or more maturity, with $250 million outstanding and has home loans, credit cards, auto loans and student loans as the “assets”. The one year return on this index as on June 30, 2016, was 4.06%.
#2 – JP. Morgan ABS Index:
This Index has over 2000 ABS instruments in the US market which are backed by different assets like auto and Equipment, Credit Card, Student Loan, consumer loans, timeshare, franchise, settlement, tax liens, insurance premium, servicing advances and miscellaneous esoteric assets. This index aims to capture about 70% of the ABS market and also has sub-indices that track specific sector ABS instruments.
ABS indices in Europe
In Europe also the ABS market is also quite matured and there are many pan European ABS indices that comprise of Asset-backed securities issued by European originators. There are ABS Indices in various other countries also. Some of them are:
#1 – Barclays Pan European ABS Benchmark Index:
This Index includes bonds that are backed by residential and commercial mortgages, auto loans and credit cards with a Eu300 million outstanding with atleast one-year maturity.
#2 – European Auto ABS Index
This ABS index comprises of Auto loan-backed securities issues by European originators.
#3 – Mexico’s Autofinanciamiento ABS Index
This ABS Index comprises of Mexican Auto loan-backed securities.
In the US and Europe, many Exchange-traded funds (ETFs) have also been developed which invest in all the bonds of the ABS index in the same proportion. These funds which are like mutual funds allow investors to put their money in a number of ABS bonds without actually investing in each of them but give them the return of an ABS portfolio.
MBS and MBS Index
As home mortgages form a very large part of the lending portfolio of the financial system, Mortgage-Backed Securities (MBS) form a majority of the securitization market. The ABS market evolved from the MBS market when it had matured and the market needed newer avenues of financing. The ABS market represents a higher risk than the MBS as they are usually shorter in duration and their cash flows are not as predictable. Also, there is a credit risk which is higher as it is not easy to separate the legal and financial aspects from the originator of the loans. Also obtaining information about the ABS is more cumbersome as there are a wide number of institutions that are involved in it from loan origination to securitization.
Tracking the MBS market helps in analyzing the health of the economy to a large extent as most mortgages have not defaulted unless it is really unaffordable for the homeowner to pay. If a large number of people start defaulting it is a clear indication that the economy is tanking. Hence there are numerous MBS indices in the US that track this market. Not only are there broad-based indices that track a large part of the market, but there are also numerous specialized MBS indices that track a part of the MBS market like only those MBS which are backed by “ subprime mortgages” or those which “issued for a certain number of years” etc.
Examples of mortgage-backed securities Index are:
#1 – S&P U.S. Mortgage-Backed Securities Index
Definition as per the S & P site is: “it is a rules-based, market-value-weighted index covering U.S. dollar-denominated, fixed-rate and adjustable-rate/hybrid mortgage pass-through securities issued by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC)” where GNMA, FNMA, and FHLMC are institutions which issue the MBS
#2 – S & P US Mortgage Backed FHLMC 30 Year Index:
This Index is a subset of the above S&P U.S. Mortgage-Backed Securities Index and tracks FHLMC issued 30 year MBS bonds.
#3 – The Deutsche Bank Liquid MBS Index:
This Index tracks the most liquid MBS in the US market.
In India, the ABS market has not yet evolved too much. The main asset classes in this market are bonds backed by auto loans, microloans, and residential mortgages. In 2013 DLF Ltd., a property development company issued a bond backed by rental income from its office buildings. In India, ABS has Non-Bank Financial Companies (NBFCs) as originators and banks as investors. Banks usually invest in these asset-backed binds to meet their “priority sector” lending norms. As the asset-backed microloans or auto loans to farmers, these help banks meet their priority sector lending. With the existing legal and tax structures, the securitization market n India is very nascent with very low demand. Due to this, there has been no need for the evolution of an ABS index.
ABS/MBS Indices & Economic Crisis
One of the biggest contributors to the 2009 economic crisis in the US has been the subprime mortgage lending, i.e. lending to entities that do not have perfect credit and have a greater risk of default. The mortgage lending was further fuelled by the securitization available for these loans which led to the market being flush with funds for further lending. It was a non-virtuous cycle of subprime lending being fuelled by more and more money being risked in the same high-risk lending. When the borrowers started defaulting the market collapse was exacerbated as not the lenders lost their money but also all those who had invested in the ABS bonds which were issued by securitizing these loans. The other set of investors who lost their money were those who invested in ABS indices linked ETFs.
When the loans have defaulted, the bonds lost their market price which in turn led to a collapse of the ABS/ MBS indices and hence all the ETFs linked to them. So one set of defaults had a cascading effect affecting three different sets of investors i.e. the lenders, the ABS investors and investors in ETFs of ABS indices. though MBS has been said as a major factor in the credit crisis it has to be said that the instrument by itself was not a reason but the subprime loans backing these instruments were the cause. Till the credit crisis, the market had been very creative in issuing MBS and ABS instruments but after the crisis, the emphasis has been on the simplicity and stability of the instrument and issuer. The issuance of exotic instruments made the indices difficult to construct and predict as there were new issues at frequent intervals with different assets and complexities in the cash flows.