3/10/2016 Introduction To Asset-Backed And Mortgage-Backed Securities - Forbes

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PERSONAL FINANCE 1/18/2013 @ 1:08PM 41,897 views

Introduction To Asset-Backed And

Mortgage-Backed Securities
Asset-
backed

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securities (ABS) and mortgage-backed securities

(MBS) are two important types of asset classes.
MBS are securities created from the pooling of
mortgages, and then sold to interested investors,
whereas ABS have evolved out of MBS and are
created from the pooling of non-mortgage assets.
These are usually backed by credit card
receivables, home equity loans, student loans and
auto loans. The ABS market was developed in the
1980s and has become increasingly important to
the U.S. debt market. In this article, we will go
through the structure, some examples of ABS and
valuation.

Structure 
There are three parties involved in the structure
of ABS and MBS: the seller, the issuer and the
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Issuers buy loans from sellers and pool them
together to issue ABS or MBS to investors. They
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vehicle (SPV). ABS and MBS benefit sellers

because they can be removed from the balance
sheet, allowing sellers to acquire additional
funding. Investors of ABS and MBS are usually
institutional investors and they use ABS and
MBS to obtain higher yields than government
bonds, as well as to provide a way to diversify
their portfolios.

Both ABS and MBS have prepayment risks,

though these are especially pronounced for MBS.
Prepayment risk is the risk of borrowers paying
more than their required monthly payments,
thereby reducing the interest of the loan.
Prepayment risk can be determined by many
factors, such as the current and issued mortgage
rate difference, housing turnover and path of
mortgage rate. If the current mortgage rate is
lower than the rate when the mortgage was
issued or housing turnover is high, it will lead to
higher prepayment risk. The path of the
mortgage rate might be difficult to understand,
so we will explain with an example. A mortgage
pool begins with a mortgage rate of 9%, then
drops to 4%, rises to 10% and finally falls to 5%.
Most homeowners would refinance their
mortgages the first time the rates dropped, if
they are aware of the information and are
capable of doing so. Therefore, when the
mortgage rate falls again, refinancing and
prepayment would be much lower compared to
the first time. Prepayment risk is an important
concept to consider in ABS and MBS. Therefore,
to deal with prepayment risk, they have
tranching structures, which help by distributing
prepayment risk among tranches. Investors can
choose which tranche to invest based on their
own preferences and risk tolerance.

One additional type of risk involved in ABS is

credit risk. ABS have a senior-subordinate
structure to deal with credit risk called credit
tranching. The subordinate or junior tranches
will absorb all of the losses, up to their value
before senior tranches begin to experience losses.
Subordinate tranches typically have higher yields
than senior tranches, due to the higher risk
incurred. Investors can choose which one they
want to invest in according to their risk tolerance
and their outlook on the market.

Examples of ABS 
There are many types of ABS, each with different
characteristics and cash flows, thus making the
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3/10/2016 Introduction To Asset-Backed And Mortgage-Backed Securities - Forbes

valuation different as well. Below are some of the

most common ABS types:

Home Equity ABS 
Home equity loans are very similar to mortgages,
which makes home equity ABS similar to MBS.
The major difference between home equity loans
and mortgages is that the borrowers of a home
equity loan usually doesn’t have good credit
ratings, hence they are not able to get mortgages.
Therefore, investors and analysts need to take a
look into the borrowers’ credit when analyzing
home equity loan-backed ABS. (Read more:
Profit From Mortgage Debt With MBS)

Auto Loan ABS 
Auto loans are a type of amortizing asset.
Therefore, the cash flows of auto loan ABS
include monthly interest, principal payment and
prepayment. Prepayment risk for auto loan ABS
is much lower when compared to home equity
loan ABS or MBS. Prepayment only happens
when the borrower has extra funds to pay the
loan off. Refinancing rarely happen when the
interest rate drops. That is because cars
depreciate faster than the loan balance, resulting
in the collateral value of the car being less than
the outstanding balance. Also, the balances of
these loans are normally small and borrowers
won’t be able to save much from refinancing
based on a lower interest rate, so there is little
incentive to refinance.

Credit Card Receivable ABS 
Credit card receivable ABS are a type of non-
amortizing asset ABS. They don’t have scheduled
payment amounts and the composition of the
pool can be changed and new loans can be added.

The cash flows of credit card receivable ABS

includes interest, principal payments and annual
fees. There is usually a lock-up period for credit
card receivable ABS during which no principal
will be paid. If the principal is paid within the
lock-up period, new loans will be added to the
ABS with the principal payment that makes the
pool of credit card receivables unchanged. After
the lock-up period, the principal payment would
be passed on to ABS investors.

Valuation 
It is important to measure the spread and pricing
of bond securities and know which type of spread
should be used for different types of ABS and

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MBS for investors. If the security doesn’t have

embedded options that are typically exercised,
such as call, put or certain prepayment options,
the zero-volatility spread (Z-spread) can be used
to measure them. The Z-spread is the constant
spread that makes the price of a security equal to
the present value of its cash flow when added to
each Treasury spot rate. For example, we can use
the Z-spread to measure credit card ABS and
auto loan ABS. Credit card ABS don’t have any
options, hence the Z-spread is appropriate.
Although auto loan ABS do have prepayment
options, they’re not typically exercised, as
discussed above, thus it is possible to use the Z-
spread to measure them.

If the security has embedded options, then we

need to use the option adjusted spread (OAS).
The OAS is the spread adjusted for the embedded
options. There are two ways to derive the OAS.
One way is from the binomial model which can
be used if cash flows depend on current interest
rates but not on the path that led to the current
interest rate. For example, callable and putable
bonds are not interest rate path dependent
therefore we can use the OAS derived from the
binomial model. The other way to derive the OAS
is through the Monte Carlo model which is more
complicated and needs to be used when the cash
flow of the security is interest rate path
dependent. MBS and Home Equity ABS are types
of interest rate path-dependent securities, thus
we need to derive OAS from the Monte Carlo
model to value them.

The Bottom Line 
Asset-backed and mortgage-backed securities are
complicated in terms of their structures,
characteristics and valuations. Investors who
want to invest in these securities can buy into
indexes, such as the U.S. ABS index. If you want
to invest in ABS or MBS directly, makes sure you
do a good deal of research, be confident of what
you are doing and make sure your investment
matches your risk tolerance.

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