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Overview of Asset-backed Securities

The asset-backed securities (ABS) market began in 1985 with transactions collateralized by automobile loans and equipment leases. By 1993 the publicly-traded ABS market had grown to over $270 billion issued and $160 billion outstanding. This growth has been fueled by the benefits that securitization of financial assets brings to both issuers and investors. For issuers, securitization has led to cheaper, more efficient funding for operations and greater balance sheet flexibility. For investors, the development of the ABS market has provided a broad selection of fixed income alternatives, most with higher credit ratings and fewer downgrades than corporate bonds and more stable cash flows than mortgage-backed securities.

Initial growth of the ABS market has come from the development of three sectors: automobile loans, credit card receivables, and home equity loans. More recently, growth has also been seen in other sectors, including manufacturing housing loans, aircraft leases, student loans, and small business loans. Development of new sectors follows the groundwork laid by the established sectors: securitizations of closed-end amortizing assets follows the model of the auto loan sector; securitizations of open-ended assets (those with no set maturity) follows developments in the credit card sector; and securitizations of mortgage-related assets will have features similar to those in the mortgage and home equity loan sectors.

The two key features of ABS are their cash flow and their credit risk. In terms of cash flows, asset-backed securities can be structured either as pass-throughs or as multiple tranches similar to collateralized mortgage obligations (CMOs). Asset-backed securities expose investors to credit risk, and all ABS are credit enhanced in order to provide greater protection to investors against losses. The amount and type of credit enhancement depends on 1) the historical loss experience of similar loans and 2) the rating sought by the issuer. The nationally recognized rating organizations that rate corporate debt issues also rate ABS, and for a given historical loss experience more credit enhancement is need to obtain a triple A rating than a single A rating.

Automobile Loans

ABS backed by automobile loans were the first major sector of the market. Automobile loans are the most straightforward type of collateral used for ABS. They generally have 6 or fewer years to maturity, are fully amortizing, and are collateralized by the automobile. Initial loan-to-value (LTV) ratios are usually 80%–90%. Most prepayments on auto loans result from trade-ins or defaults. Refinancings are almost nonexistent because loan rates are significantly higher for used autos than new ones (a loan from a refinancing would be considered a used car loan). As a result, prepayments are stable and are little affected by the level of interest rates. Compared to unsecured loans such as credit cards, defaults on auto loans are low as cars are almost a necessity and borrowers see the loss of a car through repossession as a substantial burden.

Issuance of an auto ABS begins with the creation of a special purpose trust to hold collateral on behalf of investors and to administer the distribution of cash flows. Automobile ABS can be structured in a number of ways, with a pro rata pass-through payment structure being the most common. However, since auto loans amortize over time, principal cash flows are more widely distributed than is desired by many investors who prefer short principal repayment periods. This has led to the tranching of auto ABS, similar to CMOs in the mortgage-backed securities sector. Thus, deals may include PAC tranches that are targeted to investors who want virtual certainty of cash flow, along with support tranches that offer a higher yield in return for greater cash flow uncertainty. However, the average life variability of support tranches for such deals is much less than that for CMOs.

Automobile ABS credit quality is generally quite high and loan loss rates have been very low. A “prime pool” of auto loans is characterized by relatively conservative underwriting standards, new vehicles backing the notes, maturities of less than 5 years, and an originator who has a record of low delinquency and loss performance. Additional credit enhancements are required to support transactions deviating from the prime pool characteristics. The most common credit enhancements for auto ABS are excess spread protection, subordination, reserve funds, and surety bonds.

The first line of protection for most auto ABS is excess spread, the difference between interest cash flow from the underlying loans and combined investor coupon, servicing fee, charge-offs, and trust expenses. On average, auto ABS have about 400 bp of excess protection, providing a substantial cushion against investor credit losses.

The senior/subordinated structure is widely used in the auto sector. In such an arrangement one portion of the transaction is designated as junior to the remaining portion, and obligations to the senior class are honored before the junior class in the event of a cash flow shortfall from the collateral. Junior classes, if sold, are typically credit-enhanced to receive an A credit rating.

A reserve fund is a part of the subordinated piece retained by the trust so that a portion of the junior class can be rated investment grade. The reserve fund is generally paid down over time, as the dollar amount of the required credit enhancement is reduced.

Surety bonds are guarantees of performance issued by third parties, typically AAA rated insurance companies. Surety bond providers generally guarantee the principal and interest payments of 100% of a transaction, not just the subordinated class. This type of enhancement represents a form of third-party risk, since a rating downgrade of the surety bond provider could adversely affect the rating of an ABS.

A related asset class that has been securitized is dealer floor plan loans, which are loans made to auto dealers to finance purchases of automobiles for their inventory. These loans usually have prime-based floating rates and are revolving—dealers can repeatedly borrow and repay part or all of the credit limit. Because the loans are collateralized by vehicles in inventory, floor plan loans experience low loss rates and they have high repayment rates. Most ABS backed by these loans have been issued by U.S. auto makers’ captive finance subsidiaries, but independent finance companies and banks are also floor plan lenders and are beginning to issue securities backed by these assets.

Floor plan securities are structured much like credit card securities, incorporating a revolving period, an accumulation period, and a bullet principal repayment. Floor plan ABS have unique investor protection features based on the nature of the collateral, such as provisions to repay investors early if the dealer has an abnormally high concentration of used cars in inventory. Credit enhancements, used to achieve AAA ratings, include excess spread, reserve accounts, and subordination. Floor plan ABS have been issued with 2 to 8 year maturities and with either fixed or floating coupons.

Credit Cards

Credit card securities have been the cornerstone of the ABS market, although they are now second to home equity loans in terms of volume in the ABS sector. Credit card ABS has been a growing source of funding and balance sheet relief for lenders since 1987, when the first such security was brought to market.

Credit card debt is known as revolving debt and is a key influence on the structure of credit card ABS. Credit cardholders are assigned a credit limit and can generally borrow funds up to that amount. They can repay some or all of their debt at any time, and can take on additional debt as long as the total debt is within their credit limit. Cardholders can repay as little or as much principal each month as they desire, subject to a small minimum payment. Thus, there is no true maturity for a credit card account and the amount of principal or loan may fluctuate over time.

The collateral for a credit card security is the outstanding debt (the receivables) of a group, or pool, of individual credit card accounts. The cash flow available to pay interest to investors comes from the pool’s gross revenues, which is made up of finance charges, annual fees, late charges, and interchange (the fee paid to the credit card issuer by a merchant who makes a sale charged to the card). Expenses for the pool consist of the ABS coupon, charge-offs, and a servicing fee.

An issuer creates a credit card security by first setting up a trust. Then, the issuer sells the outstanding receivables (the current balances and the future cash flows produced by the current balances) of a designated group of credit card accounts to the trust. Additionally, the issuer transfers the right to purchase, at par, any future balances generated by the same group of accounts. The balance of receivables outstanding is collateralized into two types of securities, known as investor and seller certificates. The investor certificate is sold to ABS investors and the seller certificate is retained by the card issuer. The holder of the seller certificate receives all finance charge cash flows from the receivables that remain after payment of the investor certificate coupon, the collateral pool servicing fee, charge-offs, and trust expenses. The balance of the seller certificate fluctuates over time as cardholders pay off their balances and make new purchases. The cash flow available to pay the investor coupon depends on the amount of principal outstanding. If the pool’s principal is paid down more quickly than new charges are added to the point where the balance falls below an established minimum, the seller must add more accounts to the pool.

Credit card ABS can have fixed or floating rate coupons. Interest payments, based on the investor certificate’s outstanding balance, are most often paid monthly, but are sometimes paid quarterly or semiannually. In contrast to automobile ABS, the principal is not amortized. Rather, for a specified period, the lockout period or revolving period, the investor certificate pays only interest, and principal payments are reinvested in new receivables generated by the pool. The lockout period can vary from 18 months to 10 years.

After the lockout period ends, the principal is no longer reinvested but is instead returned to investors. This period is known as the principal-amortization period. Early credit card ABS structures repaid principal by passing proportional shares of all repayments to investors and sellers until the securities were retired. But because ABS investors wanted a more predictable repayment schedule, today the securities are usually retired in one of two ways—either through controlled amortization or by bullet payments.

An ABS with controlled amortization repays, or amortizes, principal according to a set schedule, similar to a bond with a sinking fund. A scheduled principal is established and is set to a sufficiently low level so that the obligation can be satisfied even under stress scenarios.

Bullet credit card structures are designed to pay interest on a periodic basis and, on the last scheduled interest payment date, to return all principal. In this type of structure, an accumulation period follows the revolving period. During this accumulation period, borrower repayments are held in a principal funding account that generates sufficient interest to make periodic interest payments and accumulate the principal to be repaid on the maturity date.

The primary factors affecting credit quality of credit card receivables are card issuer underwriting standards and marketing methods; servicer quality; seasoning; geographic concentration; and economic conditions. Since credit card receivables are unsecured, the strength of an issuer’s underwriting criteria is critical to default performance. The method of account generation is also important. For example, a bank soliciting its own customer base may be expected to produce a more creditworthy pool of accounts than a general direct-mail campaign. Servicing quality also has a substantial impact on defaults, as a servicer that aggressively handles delinquent accounts reduces the likelihood of default. Resolving delinquencies early is important, since recoveries on unsecured card receivables are generally fairly low. Seasoning typically leads to stable default rates. In terms of geographic concentration, the more localized a pool of loans, the greater the risk if the region experiences an economic downturn. Defaults are highly correlated with unemployment and bankruptcy filings, so general economic conditions are important as well.

Most credit card ABS are rated AAA, which indicates that they have a high enough level of credit support to protect investors from all but the most traumatic economic events. Rating agencies apply a range of stress tests to each asset pool and transaction to establish a required level of credit enhancement. Thus, to create securities that withstand AAA-level stresses, issuers use credit enhancements for each credit card transaction. The most common of these credit enhancements are early amortization, letters of credit, and subordination.

Early amortization is the most powerful safeguard for credit card ABS investors. An early amortization begins if certain characteristics of the collateral pool deteriorate to some preset trigger level. When an early amortization is triggered, the security’s revolving period ends immediately and the investor certificate’s share of all further repayments is passed through to investors until the certificate is retired. Early amortization is not reversible, so once the process begins improving conditions do not halt repayment. Most securities have early amortization triggers set to a specific minimum net portfolio yield level. Other triggers protect investors from various failures of the trustee, the servicer, or the card issuer. Additionally, a seller interest trigger is tripped if the seller cannot add enough accounts to maintain the minimum balance required.

During the early years of the credit card market, the most common form of supplementary credit enhancement was a letter of credit from an AAA-rated bank. Letters of credit guarantee a specified amount of funds available to the issuer in the event of cash shortfalls from the collateral. However, letters of credit lost much of their appeal when the rating agencies downgraded the long-term debt of several letter of credit provider banks in the early 1990s. Since securities enhanced with letters of credit from these lenders faced possible downgrades as well, issuers began to issue cash collateral accounts instead of letters of credit in cases where external credit support was needed. In a cash collateral account, the issuer actually borrows the funds when the ABS are originated, instead of establishing a line of credit. These funds are available to make payments to investors, if needed.

The event risk inherent in external credit enhancements such as letters of credit has resulted in structures being increasingly dependent on internal credit support. The most widely used is the senior/subordinated structure, where a portion of the investor certificate is designated as junior (subordinated) to the remaining (senior) portion. In this structure, the obligations of the senior class are honored first in the event of a cash flow shortfall from the collateral.

Home Equity Loans

Home Equity Loans (HELs) now comprise the largest ABS sector in terms of new volume. The first HEL transaction was brought to market in 1989, and HEL volume in 1998 is expected to be around $70 billion.

A home equity loan is a secured loan made to a homeowner for which the home serves as collateral. Most such loans are subordinate to existing first mortgages; thus, HELs are essentially backed by equity in the home above any outstanding first mortgage amount. HELs are generally one of two types—second mortgages and home equity lines of credit (HELOCs).

Second mortgages have a fixed term, typically 10–15 years. All funds are borrowed at the beginning of the loan term, and the loans are generally fully amortizing. Interest rates on second mortgages are usually fixed but they can be adjustable.

HELOCs are revolving debt, similar to credit card receivables. A borrower has a specific credit limit, and periodic borrowings can be made against it. HELOCs can have either fixed or adjustable rates, but the vast majority are adjustable. They may be fully or partially amortizing, or they may have an interest-only period when no principal is repaid. Partially amortizing or interest-only HELOCs require a balloon payment. The usual term for a HELOC is 10–15 years, but some remain open for the entire time that a first mortgage is outstanding.

Both types of home equity loans involve a pledge of the home as collateral, and the default penalty (loss of the home) gives HELs inherent credit strength. If a homeowner defaults, the first mortgage lender has first claim to all proceeds from the sale of the foreclosed home, any proceeds that remain are available to the second mortgage lender. If the home has retained its value and if the second mortgage was prudently underwritten, both lenders may recoup their principal. The problematic scenario for a second mortgage holder is a situation in which there is a substantial drop in home values. However, the average combined loan to value ratio (CLTV) for home equity loans is around 65%, so there would have to be substantial price decreases at that level before a default would result in a loss to the HEL lender.

Home equity loans can generally be prepaid at any time, and prepayments are passed on to investors at par. Thus, prepayment rates that are faster than expected will improve the yield of an HEL security purchased at a discount and will decrease the yield of a security purchased at a premium. Changes in prepayment rates may also lengthen or shorten the average life of a security. Prepayments of second mortgages are at least partially determined by refinancings of first mortgages, and are difficult to project without knowing the specific details of the first mortgage.

From a default perspective, home equity loans perform much like first mortgages. Overall default rates are low and are highly correlated with regional property value changes, unemployment rates, and bankruptcy filings. Higher default rates are generally seen for loans with high CLTVs, adjustable rates, or lax underwriting standards such as high debt-to-income ratios. Default rates also tend to be higher for nonamortizing balloon loans and for loans for vacation or investment homes.

Credit ratings for HELs are primarily determined by the underlying assets, and factors that increase the default risk of a collateral may be offset by other factors that lower the default risk and/or improve the expected recovery rate. For example, nonamortizing HELOCs would normally need to provide credit support above the level needed for amortizing HELs. However, if the lender’s underwriting standards had a low maximum CLTV, the rating agencies would take this into account.

Most HELs are completely or partially credit-enhanced by a surety bond. Surety bonds, especially those that wrap 100% of the transaction, are often prohibitively expensive for other ABS classes. However, they are popular for HEL’s because the low default rate of the collateral makes the coverage affordable, and the coverage period is in the range desired by surety bond companies. Other credit enhancements used for HELs include cash collateral, reserve accounts, overcollateralization, and subordination.

Other Asset Classes

Other asset classes used for ABS include manufactured housing, recreational vehicles, leases, student loans, and trade receivables. Since almost all debt and cash flow streams can be securitized, other types of ABS are likely to emerge as issuers try to make their assets more homogeneous and better suited to the securitization process.

J. Wade Luther E-mail, CFA, ASA, MAAA
April 1999

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