Asset-backed securities (ABS) and mortgage-backed securities (MBS): an overview
Asset-backed securities (ABS) and mortgage-backed securities (MBS) are the two most important asset classes in the fixed income sector. MBS was created by pooling mortgage loans sold to interested investors, while ABS was created by pooling non-collateralized assets. These securities are usually backed by credit card accounts receivable, home equity loans, student loans and auto loans. The ABS market developed in the 1980s and became more and more important to the US debt market. Despite their obvious similarities, there are key differences between the two types of assets.
The structure of these types of securities is based on three parties: seller, issuer, and investor. The seller is a company that issues loans to the issuer and acts as a service provider, and collects principal and interest from the borrower. ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to obtain additional funds.
Issuers buy loans from sellers and pool them together to issue ABS or MBS to investors, and it can be a third-party company or special purpose vehicle (SPV). Investors in ABS and MBS are usually institutional investors who use ABS and MBS to try to obtain higher yields and provide diversification than government bonds.
- Asset-backed securities (ABS) are created by pooling non-collateralized assets (such as student loans). Mortgage-backed securities (MBS) are formed by pooling mortgage loans.
- ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to obtain additional funds.
- Both ABS and MBS have prepayment risks, although these risks are particularly obvious in MBS.
- ABS also has credit risk, and they use a high-level-subordinate structure (called credit grading) to deal with the risk.
- A variety of methods can be used to value ABS and MBS, including zero volatility and option adjusted spreads.
Asset-backed securities (ABS)
There are many types of asset-backed securities, each with different characteristics, cash flow and valuation. The following are some of the most common types.
Home Stock ABS
Home equity loans are very similar to mortgage loans, which in turn makes home equity ABS similar to MBS. The main difference between home equity loans and mortgage loans is that the borrowers of home equity loans usually do not have a good credit rating, which is why they cannot obtain a mortgage. Therefore, investors need to review the credit rating of the borrower when analyzing the ABS supported by home equity loans.
Auto loan ABS
Auto loan is a kind of amortized asset, so the cash flow of auto loan ABS includes monthly interest, principal payment and early repayment. Compared with home equity loan ABS or MBS, the risk of prepayment of auto loan ABS is much lower. The prepayment will only occur when the borrower has additional funds to pay for the loan.
When interest rates fall, refinancing is rare, because the car depreciates faster than the loan balance, causing the value of the car’s collateral to be lower than the outstanding balance. The balance of these loans is usually small, and the borrower will not be able to save a lot of money from refinancing at a lower interest rate, so there is little incentive to refinance.
Credit card accounts receivable ABS
Credit card accounts receivable is a non-amortized asset ABS. They do not have a predetermined payment amount, but can add new loans and changes to the composition of the pool. The cash flow of credit card accounts receivable includes interest, principal payment and annual fees.
Credit card accounts receivable usually have a lock-up period and no principal will be paid. If the principal is paid within the lock-in period, the new loan will be added to the ABS, and the principal payment will keep the credit card accounts receivable pool unchanged. After the lock-up period, the principal payment will be passed on to ABS investors.
Mortgage-backed securities (MBS)
Most mortgage-backed securities are issued by Ginnie Mae (Government National Mortgage Association), Fannie Mae (Federal National Mortgage Association), or Freddie Mac (Federal Home Loan Mortgage Corporation), all of which are companies funded by the US government.
Ginnie Mae’s MBS is backed by the full trust and credit of the US government, ensuring that investors receive full and timely principal and interest payments. In contrast, Fannie Mae and Freddie Mac MBS do not have the full trust and credit support of the US government, but they both have the special power to borrow from the US Treasury when necessary.
Most full-service brokerage companies and some discount brokers can purchase mortgage-backed securities. The minimum investment is usually $10,000; however, there are some MBS variants, such as mortgage-backed bonds (CMO), which can be purchased for less than $5,000. Investors who do not want to invest directly in mortgage-backed securities but want to access the mortgage market can consider investing in exchange-traded funds (ETFs) in mortgage-backed securities.
Well-known ETFs that invest in MBS include iShares MBS ETF (MBB) and Vanguard Mortgage-Backed Securities Index ETF (VMBS). ETF trading is similar to stocks on regulated exchanges, which can be short-sold and purchased on margin. Like stocks, the price of ETFs fluctuates during each trading session with market events and investor activities.
special attention items
Both ABS and MBS have prepayment risks, although these risks are particularly obvious in MBS. The risk of early repayment means that the borrower pays more than their monthly repayment amount, thereby reducing loan interest. The risk of early repayment can be determined by the difference between current and issued mortgage interest rates, housing turnover rate and mortgage interest rates.
For example, if the mortgage interest rate starts at 9%, drops to 4%, rises to 10%, and then drops to 5%, the homeowner may refinance their mortgage when the interest rate drops for the first time. Therefore, in order to deal with the risk of early repayment, ABS and MBS have a tiered structure to help share the risk of early repayment. Investors can choose a grade according to their preferences and risk tolerance.
Another risk involved in asset-backed securities is credit risk. ABS has a high-level-subordinate structure to deal with credit risk called credit grading. Before the high gear starts to suffer losses, the secondary or primary gear will absorb all losses to its value. Due to the higher risk, the return rate of the second grade is usually higher than that of the high grade.
Asset-backed securities and mortgage-backed securities can be very complex in terms of their structure, characteristics, and valuation. Investors can obtain these securities through indexes such as the US ABS Index. For those who want to invest directly in ABS or MBS, you must conduct a thorough research and weigh your risk tolerance before making any investment.
ABS and MBS example
It is important to measure the spread and pricing of bond securities and understand the types of spreads applied to different types of ABS and MBS. If the security does not have embedded options, such as call options, put options, or certain prepayment options, you can use Z-spread as a measure. Z-spread is a constant spread. When added to the spot interest rate of each Treasury bond, it makes the price of the security equal to the present value of its cash flow.
For example, we can use Z-spread to measure credit card ABS and auto loan ABS. Credit card ABS does not have any options, so Z-spread is a suitable metric. Although auto loan ABS does have pre-payment options, they are usually not exercised, so they can be measured by the Z spread.
If the security has embedded options, the option adjusted spread (OAS) should be used. OAS is the spread adjusted for embedded options. If the cash flow depends on the current interest rate but not the path leading to the current interest rate, then a binomial model can be used to derive OAS.
Another way to derive OAS is through the Monte Carlo model, which is needed when the cash flow of securities is related to the interest rate path. MBS and Home Equity ABS are types of securities related to the interest rate path, in which the OAS in the Monte Carlo model will be used for valuation. However, this model can be very complex, and its accuracy needs to be checked throughout its use.