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 very large number of small loans
into a single financing vehicle. The vehicle which then issues a small number
of different tranches of debt with varying seniority. Fundamentally, these
transactions mirror 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 three key drivers for these structures:
- To fund a pool of loans at a total cost that is lower than the interest income received, and
- To segregate the loans from the credit quality of the originator.
- To allow wholesale investors access to investment
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 an 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 of seniority.
The most senior notes,
typically called Class A notes, will receive their entitlement first, 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 and can 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). This interest rate would be lower than the
interest rate paid by any single underlying borrower. As such, every single
borrower notionally pays their share of the interest due on the rated classes
and a little extra which contributes 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 passed through the structure. As the individual borrowers repay the
principal the ABS structure repays the principal to the investors.
At the outset, the principal is
paid in order of priority. While there might seem to 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. Without the subordinated junior tranches,
the higher-rated tranches would not have the high ratings and the low-interest
costs that come with it. So the senior tranche must be paid first.
Although only the most senior
tranche is initially 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. Essentially, after the front of the queue is paid, each member
of the queue moves up one place in line – at least in a proportionate sense.
After a period of time and if
provided the overall transaction performs broadly as expected, the allocation
of principal can change. Sometimes, the
payments will 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 the amount outstanding against the total amount
outstanding.
Master Trust Arrangements
A variation on an ABS is
something called a Master Trust. Up until now, we’ve talked about ABS with what
is called a “closed pool”. Namely, once the ABS is launched the loan assets in
the pool are specified and cannot change.
In a Master Trust, the issuer
is allowed to add new loans into the pool – under certain conditions, we call
these revolving or prefunding structures. Such pools include eligibility
criteria, i.e. conditions on what assets can be added to the pool. These
criteria vary based on the assets under consideration, but rules around average
loan size, concentration, loan age, minimum and/or weighted-average pool
interest rate and exposure to any one borrower are common. Furthermore, there
will often be other conditions related to portfolio performance called
portfolio parameters based on delinquencies or annualized loss rates, the
interest income in the trust and the excess spread earned.
These Master Trusts are riskier for investors because the pool can change. However, they are very
valuable to borrowers because they allow a bank or non-bank financial to fund
their ongoing business model.
ABS loan performance
Although ABS transactions are
very similar to RMBS transactions, there is inherently a lot more historical
data available to assess the 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 into 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 disproportionally large 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.
The 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.