Introduction:Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically, these assets consist of receivables other than mortgage loans,1 such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans. ABS differ from most other kinds of bonds in that their creditworthiness (which is at the triple-A level for more than 90% of outstanding issues) derives from sources other than the paying ability of the originator of the underlying assets.Financial institutions that originate loans including banks, credit card providers, auto finance companies and consumer finance companies turn their loans into marketable securities through a process known as securitization. The loan originators are commonly referred to as the issuers of ABS, but in fact they are the sponsors, not the direct issuers, of these securities.During the financial crisis that began in late 2007, many investors experienced losses related to private label RMBS, CMBS, and MBS-backed CDOs.
This dislocation exposed investors who based their investment decisions primarily on ratings, guarantees from monoline insurers, and a blind faith in stable or increasing real-estate prices. Even those structured credit investors wise enough to avoid MBS and related securities experienced some combination of price declines, illiquidity, and ratings downgrades. As a result, many structured credit investors, bruised and shell-shocked, remained on the sidelines during the subsequent recovery that began in early 2010 and missed out on the associated returns. Even today, many investors remain reluctant to allocate to funds and strategies that are exposed to securitized credit. While intrigued by the additional yield offered by structured credit versus similarly rated corporate or municipal credit, skeptical investors worry that the credit losses and illiquidity following 2007 lurk around the corner. The growth in ABS came to a sudden end with the financial crisis that started in 2007, which was characterized by a global credit crunch. The crisis began with a decline in house prices and an increase in mortgage defaults, particularly on subprime mortgages (high-risk loans to borrowers with poor credit).
Uncertainty quickly spread to other consumer loan markets, such as those based on car loans, credit cards, and student loans. In July 2007, ABS issues backed by residential mortgages dried up. The failure of Lehman Brothers in October 2008 was a big shock to the financial markets and to investor confidence, and yields on ABS skyrocketed.2 In this new high-yield environment, there was no economic incentive for lenders to issue new ABSAfter a solid decade of growth, overall asset-backed securities (ABS) issuance declined by 29 per cent in 2007 versus the full year of 2006 (see Figures 1 and 2). US issuance of approximately $864 billion was the lowest level since 2004, when aggregate securitization volume was $858 billion.
The subprime residential mortgage-backed securities (RMBS) sector, the largest source of securitization activity, declined by an unprecedented 58 per cent, while collateralized debt obligations (CDOs), the second largest sector, declined by nearly 11 percent, Wider spreads in the second half of 2007 led to an issuance slowdown in other sectors as well, notably equipment, student loans and autos. The credit card sector was the only major asset class to experience an overall increase in supply from the prior year’s levels.The year 2007 will also be remembered as a year of unprecedented rating volatility. An estimated $300 billion of securities were downgraded in 2007, the worst year on record.
The next highest year was 2003, when $142 billion of securities were downgraded. Ninety-five per cent of the downgrade activity was related to two sectors: sub-prime RMBS and CDOs backed by sub-prime RMBS. Downgrades were heavily concentrated in the most recent vintage years; for example, by our estimates, nearly two-thirds of the 2006 ABS CDOs have been downgraded or are currently under review for downgrade.
In the past, historically low levels of rating migration meant that there were few opportunities in noninvestment grade securities. The market for high-yield corporate debt creates a natural home for investment grade corporates that have been downgraded. And the distressed corporate market creates a home for high yield corporate credit that has been downgraded.
But these markets have historically not existed for ABS. One of the reasons why liquidity is so poor for downgraded. ABS is that few investors have made a commitment to the tools and personnel needed to evaluate the bonds. That is no more the case.
And while the emergence of distressed ABS funds has the potential to create a more efficient exit strategy for investors wanting to sell, it is likely that having a bottom buyer in this market could potentially have a positive impact on liquidity on higher parts of the capital structure as well.Highlights in ABS market in U.S? Securitization begins with the creation of a special purpose vehicle that acquires a pool of assets and simultaneously issues asset-backed securities to fund the purchase of those assets.? The pool of securitized assets are contractual obligations to pay that are typically the same type (auto loans, aircraft leases, credit card receivables, corporate loans, etc.) but represent diverse payers.? With $1.3 trillion outstanding, non-mortgage ABS represents just 4 percent of the fixed-income universe.
? ABS debt boasts investor-friendly features that may help protect against loss and improve liquidity, including bankruptcy remoteness, prioritization of payments, overcollateralization, excess spread, amortization, professional servicing, and diversity of payers within each underlying pool.? Despite these and other strengths, ABS have offered higher yields than similarly rated municipal or corporate bonds.? Securitizations fund lenders, lessors or other specialty finance companies, or provide debt capital to traditional corporate borrowers that have contracts that are considered to be of higher credit quality than the corporation’s own unsecured debt.
We illustrate such a situation with a case study.? Successful investment in structured credit requires dedicated credit, trading, technology, and legal resources, institutional knowledge, and a disciplined investment process.Reference:https://www.statista.com/statistics/189279/issue-volume-of-asset-backed-securities-in-the-us-since-1990/file:///C:/Users/GOOGLE/Downloads/4qtr2010-part1-agarwal-barrett-cun-denardi-pdf.pdf
