While most investors may be familiar with Residential Mortgage Backed Securities (RMBS), Asset Backed Securities (ABS) securities are lesser known, but can offer higher returns compared to vanilla corporate bonds. Here we look at this type of fixed income
security and how they work.
Transaction Structure
Asset-backed securitisation is a funding technique that allows the pooling of a large number of loans into a single financing vehicle, which then issues a number of different tranches of debt with varying seniority. Fundamentally, these transactions are
mirroring structures that pool residential loans and issue residential mortgage-backed securities (RMBS). The main difference being that residential mortgage loans will typically have maturities of 20 to 30 years whereas asset-backed loans will be
significantly shorter (typically no more than seven years).
There are two key drivers for these structures:
- to fund a pool of loans at a total cost that is lower than the interest income received, and
- segregate the loans from the credit quality of the originator.
As represented in Figure 1 above, a trust (i.e. a special purpose vehicle) will issue a number of tranches of debt (with ratings typically ranging from AAA to BB) and will use the proceeds to purchase a portfolio of loans from the originator. Similar
to an RMBS structure, the trust will issue a deeply subordinated tranche that will be retained by the originator, which could be viewed as akin to equity. This tranche entitles the holder to residual cash flow but is first in line in terms of loss
absorption.
As can be expected, all the loans purchased by the trust have different terms. In the case of an equipment loan securitisation, key terms will include the tenor of the loan, interest paid by the underlying borrower, amortisation schedule (including if
there is an interest-only period and if the loan fully amortises or has a residual balloon payment), nature / identity of the borrower and loan-to-value ratio (i.e. how much of the equipment value has been debt financed).
Cash flow mechanics
The cash flow allocation in an ABS structure is similar to any RMBS. The trust will receive two separate streams: interest on the underlying loans and principal repayment. All the interest payments will be pooled together and will be paid to all the various
classes of notes issued, in order to seniority.
Class A notes (typical naming convention for the most senior tranche) will receive its entitlement, then the Class B and all other more junior tranches. To the extent the aggregate of all interest payments received is greater than the aggregate of interest
owed to the various classes of notes, any surplus cash (after coverage of any losses) will be paid to the equity tranche.
In a typical transaction, there will be a relatively sizeable income surplus after paying interest on the most junior rated tranche (referred to as ‘excess spread’). This is the first protection in an ABS (or RMBS) structure which could be
viewed as a form of cross-collateralisation.
Another way to look at it is to consider the weighted average interest rate for all the issued tranches (except the equity tranche) which would be lower than the interest rate paid by any underlying borrowers. As such, every single borrower notionally
pays its share of the interest due on all the rated classes and contribute to the coverage of any borrowers that default under an individual loan.
The second cash flow stream relates to amortisation payments from each individual loan. Since the aggregate of all the loans transferred into a trust will be equal to the aggregate of all classes of notes (including the equity tranche) issued, the principal
payments are simply pass through the structure.
At the outset, principal is paid in order of priority. While there could be an incentive to pay down the most junior tranches first (due to their higher interest cost), the priority given to the most senior tranche is one of the key reasons why these
tranches can be rated as high as AAA, reflecting their payment priority for both interest and principal.
Although only the most senior tranche is being repaid, all the other tranches indirectly benefit. This is because, for a given class of notes, the amount (in dollar terms) of notes ranking behind will remain the same while the total transaction size will
decrease, hence the protection for that class (as a percentage of the total transaction) will increase.
After a period of time and provided the overall transaction performs broadly as expected, the allocation of principal would switch to a pro-rata methodology, i.e. for every dollar of amortisation received, it will be allocated across all tranches (except
the equity tranche) based on their then amount outstanding against total amount outstanding.
ABS loan performance
Although ABS transactions are very similar to RMBS transactions, there is inherently a lot more historical data available to assess performance of residential loans depending on borrowers / loan terms. As a result, the assessment and analysis of ABS transactions
has a greater reliance on originator specific data around underwriting standards, loan terms and historical performance. One key data point used by rating agencies is what is commonly referred to as the vintage loss curve.
Figure 2 below shows Metro Finance’s vintage gross loss rate. All the loans originated in a given quarter are assessed as a distinct portfolio and each quarterly curve then looks at the amount of losses over time, with the start of each curve starting
at 0 in the horizontal axis. As can be seen, the oldest curve (Q3 2014) is the line that goes furthest on the right. These vintage curves provide a very good insight of the strength of the underwriting for a given originator although it might be necessary
to exclude certain outliers (as was the case below, with the 2015Q1 line) provided the exclusion can be substantiated (in this example, the amount of loans for older vintages would have been significantly lower than currently, hence a single loss
would have had a proportionally greater impact).
Capital structure
There are a number of variables that will determine the actual repayment profile of the overall structure. The two key data points are the prepayment rate (or CPR, i.e. representing borrowers repaying their loans ahead of schedule) and ongoing losses.
A market convention is that, for the purpose of cash flow modelling, only CPR is adjusted, with the assumption that other loss absorbing features (namely excess spread, loss recovery and subordination) would be sufficient to cover any ongoing losses incurred.
The final variable to decide is the call date. ABS and RMBS transactions will typically incorporate an early call date which could either be date-based or linked to the total outstanding amount falling below a given threshold.
Market convention is that investors assume these transactions will be called at the earliest opportunity, and there is a very strong track record across issuers and originators as it will generally materially influence investors’ appetite.
When we assess ABS transactions, we don’t just rely on the analysis of the rating agencies but undertake a detailed analysis of the structure, meet management and assess historical performance to ensure we are comfortable with any proposed transactions.
Reasons we might discount certain deals include a poor historical track record of performance (even if compensated by larger protection), limited performance history, large proportion of illiquid underlying assets.