Asset Backed Securities (ABS)
Asset backed securities are bonds or notes backed by specific assets.
They are created when companies take the cash flows from illiquid assets,
(in most cases receivables), turn them into marketable securities, and sell
the securities to a third party for cash. The receivables and associated
debt are normally transferred to an off-balance sheet (bankruptcy protected)
subsidiary. The originating company usually continues to collect the
receivables, and forwards the interest and principle payments, when
collected, to the buyer. Some of the newer type structures, in order to
extend the average life of the transaction, and lower the overall cost,
allow for additional receivables to be added to the credit facility and
While the process has become routine, the concepts are very
sophisticated. I view the process as “slicing and dicing” the cash flow
streams of any assets, into a number of ways, then discounting those streams
at market rates, and selling them to investors.
The typical, non-mortgage asset classes are: auto loans, credit cards,
home-equity loans, insurance premiums, leases, student loans, and other
installment sales contracts. The big institutional investors are the
insurance companies and banks. They need to match their cash inflows from
their investment portfolios to their pension and life insurance obligations
as they come due. That said, pension and life insurance funds are fiduciary
monies, and need to be invested in investment grade securities.
In order to achieve an investment grade rating by the major rating
agencies, a credit enhancement (protection against default) is needed to
ensure that cash flows will be available to pay the note holders.
Getting an investment grade rating is more then substantiating the
collectability of the assets. The rating agencies need to evaluate the
underwriting standards, contracts, legal structure and the servicing
capabilities. There are a number of different credit enhancement techniques
used to convert a risky cash flow stream into a creditworthy one.
The main types of credit enhancements are:
Cash collateral accounts
Credit risk reserve accounts
Substitution of defaulted collateral with good collateral
Irrevocable letter of credit
Insurance policy – surety bond
Cross collateralization with the parent or sister company
Credit enhancements insure note holders will be paid.
While non-mortgage asset backed securities are primarily private place
deals, more are now becoming public.
Don’t consider prepayments to be a risk; getting paid back is always a
good thing. Prepayments are part of the business; in most cases they are
Structures are customer driven, and features include: interest only, full
amortization, non-amortization loans and bullet structures. Fixed and
floating rates are also available.
These are solid investments! Be comfortable with the issuer / servicer,
because maintenance of the underlying assets, at a profitable level, is
complicated. Preparing the servicing reports is difficult. Realize that the
monthly payments received by the investors consist of interest, return of
scheduled principle payments and prepayments.
Regarding young adults, I view
asset backed securities more for those investors looking for steady cash