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Introduction to ABS Structures
Asset-Backed Security (ABS) structures are a form of securitization where cash flows from a pool of underlying assets are collected and then redistributed to investors through a series of prioritized payments. By dividing these cash flows into different bonds, or tranches, with distinct risk and return profiles, ABS structures can efficiently transfer and redistribute risks like default and prepayment.
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Covered Bonds
Covered bonds are a simpler, lower-risk form of securitization, popular in Europe. They are senior debt instruments issued by financial institutions and backed by a distinct pool of high-quality assets (typically mortgages).
Key Features and Advantages
| Feature | Description |
|---|---|
| Dual Recourse | This is the most important feature. Investors have a claim on both the segregated asset pool (the "cover pool") AND the issuer's other assets. This provides two layers of protection. |
| On-Balance-Sheet | Unlike true ABS, the loans in the cover pool remain on the issuer's balance sheet. |
| Dynamic Cover Pool | The pool is constantly monitored, and any non-performing assets must be replaced by the issuer, ensuring the collateral quality remains high. |
| Over-Collateralization | The value of the assets in the cover pool is required to be greater than the face value of the covered bonds, providing a protective buffer. |
| Risk & Yield | Due to these strong protections, covered bonds have very low risk and, consequently, offer lower yields than most other types of ABS. |
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ABS Structures to Address Credit Risk
In a true securitization, the primary method for managing credit risk is through credit enhancement, which aims to improve the credit quality of the issued securities above that of the underlying collateral pool. This is most commonly achieved by creating a prioritized payment structure.
Credit Tranching (Subordination) and the Waterfall Structure
Subordination is the most common form of internal credit enhancement. The ABS are issued in different classes, or tranches, that have a strict hierarchy for receiving payments and absorbing losses. This is known as a "waterfall" payment structure.
- How it Works: All cash flows collected from the underlying asset pool flow into the structure. Payments of interest and principal are then made sequentially down the waterfall. The highest-ranking tranche is paid first, then the next-highest, and so on.
- Loss Absorption: If there are losses in the underlying collateral (e.g., from loan defaults), they are absorbed from the bottom up. The most junior tranche absorbs the first losses, protecting the more senior tranches.
- Investor Choice: This structure allows investors to choose a tranche that matches their risk appetite. Conservative investors buy the low-risk, low-yield senior tranches, while investors seeking higher returns can buy the higher-risk, higher-yield junior tranches.
Other Forms of Credit Enhancement
| Type | Mechanism |
|---|---|
| Internal: Overcollateralization | The total principal value of the collateral in the pool is greater than the total principal value of the ABS bonds issued. |
| Internal: Excess Spread | The interest rate received from the underlying collateral is higher than the interest rate paid to the ABS bondholders. This extra cash flow can be used to cover losses. |
| External | A third party provides a guarantee or a letter of credit to cover any losses in the structure. |
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Non-Mortgage Asset-Backed Securities
While mortgages are a common form of collateral, ABS can be created from a wide variety of other assets.
- Amortizing ABS: Backed by assets that have a scheduled series of principal and interest payments, such as auto loans. As the underlying loans are paid down, the principal is passed through to the investors.
- Non-Amortizing (Revolving) ABS: Backed by assets that do not have a regular principal repayment schedule, such as credit card receivables. During an initial "lockout period," any principal repayments from the receivables are used to purchase new receivables, keeping the pool balance stable. After the lockout period, the principal is passed through to investors.
Examples of Non-Mortgage ABS
| ABS Type | Description |
|---|---|
| Credit Card Receivable ABS | Backed by a pool of credit card debt. The cash flows to investors come from the finance charges, fees, and principal repayments made by cardholders. These are typically structured as revolving ABS. |
| Solar ABS | A growing category of ABS backed by loans for solar energy systems and home energy improvements. They are popular with institutional investors due to their environmental benefits and are protected by standard credit enhancement features. |
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Collateralized Debt Obligations (CDOs)
Collateralized Debt Obligations (CDOs) are securities that are themselves backed by a pool of other debt obligations. The goal of a CDO is to generate a return for the most junior tranche (the "equity" tranche) from the spread between the interest earned on the collateral and the interest paid to the more senior debt tranches.
Types and Structure
- Types by Collateral:
- Collateralized Loan Obligations (CLOs): Backed by a pool of leveraged bank loans. This is the most common type of CDO in the post-financial crisis era.
- Collateralized Bond Obligations (CBOs): Backed by a pool of corporate bonds.
- Active Management: Unlike many static ABS pools, the collateral portfolio in a CDO is often actively managed by an asset manager.
- Investor Protection: The debt tranches are protected by the cash flow waterfall and a series of performance tests that ensure the collateral pool is generating enough cash and remains sufficiently diversified.