 Personal Finance Powerpoint Presentation, Asset Back Security ABS. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Asset Back Security ABS, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated October 9th, 2021. In prior presentations, we've been looking at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is an asset back security, an ABS? An asset back security ABS is a type of financial investment that is collateralized by an underlying pool of assets, usually one that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. So often on the investment side of things, we're typically looking to have a diversified portfolio. We might be putting some of our money into equities, into stocks, which have a level of volatility that might be higher than fixed income, such as bonds, but which has a potential possibly for a greater gains. Then we might have some investments in fixed incomes, which could include something like bonds, could include other asset backed types of securities. When we invest in something like a bond, we are in essence basically loaning money to the issuer. We can think first, possibly of government bonds, because they're a good tool to compare against because they have very low, if not zero default risk, the likelihood that they don't pay back, basically the bonds. And then we can take a look at corporate bonds, which have a little bit more risk involved in them and so on. And then we can look at other types of investment strategies and tool, asset backed security ABS, looking for another way to help kind of support or secure the investment with that asset backed security. So it takes the form of a bond or note, paying income at a fixed rate for a set amount of time until maturity. So the format of it, the structure of it, similar then to a bond or fixed income type of instrument we're investing in. For income oriented investors, asset backed security can be an alternative to other debt instruments like corporate bonds or bond funds. So fixed income investors, possibly those that want that part of their portfolio or possibly those that are in like retirement or something like that, looking for that fixed income because it's what they're gonna be living on. So understanding asset backed security, ABS is, asset backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often e-liquid and can't be sold on their own. So pooling assets together and creating a financial instrument out of them, a process called securitization, allows the issuer to make e-liquid assets more credible to investors. You got these assets that can't easily be bought and sold because they're e-liquid and you're gonna be putting them in such a structure that they can't be more liquid in essence, being able to be buying and selling them more readily. So it allows, it also allows them to get shaker assets off their books, thus alleviating their credit risk. The other underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft, landing slots, toll rules and solar photovoltaics, which I'm sure they're really creative on that one. I think they just made up that word entirely, but then they made an investment strategy on it and somehow so in any case, just about any cash providing vehicle or situation can be securitized into an ABS. So for investors buying an ABS offers the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income generating assets, sometimes as noted above exotic ones that aren't available in any other investment. So that's a definitely exposure to some diversification that you might not get on the standard rotation. So how an asset backed security works, assume that company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, company X gives that person the cash and the person is obligated to repay the loan with a certain amount of interest. So they're financing the car, you would think the car would be used as collateral on the loan and so on. Perhaps company S makes so many loans that it starts to run out of cash. So now they're selling their cars, they got a cash flow problem in their business, they're making revenue, but they need a cash flow component. So company X can then package its current loans and sell them to investment firm X, thus receiving the cash, which it can then use to make more loans. So if they sell the loans bundling, basically sell the loans, I can, they can allow them to liquidate or get the cash flow from the loans at the point in time they needed for their cash flow needs. So invest possibly buying more cars, obviously and so on, so they can keep growing. Investment firm X will then sort the purchased loans into different groups called trenches and the trenches contained loans with similar characteristics such as maturity, interest rate and expected delinquency rate next. So now we're sorting the loans out into similar characters. So investment firm X will issue securities based on each trench it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness that is the likelihood the underlying loans will go into default. So then you gotta of course look at these different loans and kind of put them into categorizations and try to determine what the likelihood of default is so that we can get some idea of risk involved here. Individual investors then purchase these securities and receive the cash flow from the underlying pool of auto loans, munis on administrative fee minus an administrative fee that investment firm X keeps for itself. So obviously it's gonna take some cost on the investment firm to be structuring these items. Special considerations, an ABS will usually have three tranches, class A, B and C. The senior trench, A is almost always the largest trench and is structured to have an investment grade rating to make it attractive to investors. So obviously we would like the higher investment grade rating typically, which would be the more secure investments to have a more assurance on the income stream. The B tranche has lower credit quality and thus has a higher yield than the senior trench. So obviously when you're looking at the B area, you're saying, okay if I have the opportunity of going to the less risk or the more risk, if there's more risk involved, I expect to get a greater return. So you got a greater return possibly here, but then of course you take on the greater risk along with it, the C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. That's not good. In this case, the issuer would keep the C tranche and absorb the losses. Types of asset-backed securities theoretically and asset-based security, types of asset-backed securities theoretically and asset-based security ABS can be created out of almost anything that generates an income stream from mobile home loans to utility bills, but certain types are more common. Among the most common ABS are the collateralized debt obligation, the CDO. A CDO collateralized debt obligation is an ABS, which is an asset-backed security issued by a special purpose vehicle, SPV. The SPV, the special purpose vehicle, is a business entity or trust formed specifically to issue the ABS, the asset-backed security. So there are a variety of subsets of CDOs, which are the collateralized debt obligations, including collateralized loan obligations, CLOs or CDOs made up of bank loans, collateralized bond obligations, CDOs are composed of bonds or other CDOs. Structure finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages or real estate investment trust, REIT, REIT debt. Cash CDOs are backed by cash market debt instruments, while other credit derivatives support synthetic CDOs. Collateralized mortgage obligations, CMOs are composed of mortgages or more precisely mortgage-backed securities, which hold portfolios of mortgages. Through a CDO is essentially structured the same as an ABS, some considered a separate type of investment vehicle. In general, a CDOs own a wider and more diverse range of assets, including other asset-based securities or CDOs. Home equity ABS, home equity loans are one of the largest categories of ABS. Those similar to mortgages, home equity loans are often taken out by borrowers who have less than stellar credit scores or few assets, the reason they don't qualify for a mortgage. These are amortizing loans. That is, payment goes towards satisfying a specific sum and consists of three categories, interest, principal and prepayment. So when you think about obviously the flow of the loan for an amortizing loan, each payment usually is gonna be consisting of a portion interest, a portion principal, and you could have then the prepayment in effect as well. So auto loan ABS, car financing is another large category of ABS. The cash flow of an auto loan ABS include monthly interest payment, principal payments and prepayments, though the latter is rarer for an auto loan ABS and is much lower when compared to in home equity loan ABS. This is another amortizing loan. We've got the credit card receivable ABS, credit card receivables, the amount due on credit card balances are a type of non-amortizing asset ABS. So we don't have the same kind of amortizing table, for example, when you're paying back, say a credit card loan, you pay back basically the minimum payment basis is required and so on and so forth. So they go to a revolving line of credit rather than toward the same set sum. So they can't have fixed payment amounts while new loans and changes can be added to the composition of the pool. So the cash flow of credit card receivables include interest, principal payments and annual fees. There is usually a lockup period for credit card receivables where no principal will be paid. If the principal is paid within the lockup period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the lockup period, the principal payment is passed on to ABS investors. Then we've got the student loan ABS. ABS's can be collateralized by either government student loans guaranteed by the US debt of education or private student loans. The former have had a better payment record and a lower risk of default. And ABS will usually have three tranches. You've got class A, B and C. The senior tranche A is almost always the largest tranche and is structured to have an investment grade rating, a good rating to make it attractive to investors. The B tranche has lower credit quality and thus has a higher yield than the senior tranche. So once again, more risk with this with the less quality investment possibly comes along with a higher rate of return that could be possible but more greater likelihood for loss. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can't be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses. What is an example of an asset backed security? A collateralized debt obligation, CDO is an example of an asset based security ABS. So it is like a loan or bond one backed by a portfolio of debt instruments, bank loans, mortgages, credit card receivables, aircraft leases, smaller bonds and sometimes even other ABSs or CDOs. So this portfolio acts as collateral for the interest generated by the CDO which is re-appaid by the institutional investors who purchase it, reaped by the individual investors who purchased it. What is asset backing? Asset backing refers to the total value of a company shares in relation to its assets. Specifically, it refers to the total value of all the assets that a company has divided by the number of outstanding shares that the company has issued. In terms of investments, asset backing refers to a security whose value derives from a single asset or a pool of assets. These holding act as collateral for the security backing it in effect. So what does ABS stand for in accounting? In the business world, ABS stands for, quote, accounting and billing system and quote, what is the difference between MBS and ABS? An asset based security ABS is similar to a mortgage backed security MBS. Both are securities that like bonds pay a fixed rate of interest derived from an underlying pool of income generating assets usually debts or loans. The main difference is that an MBS as its name implies consists of a package of mortgages real estate loans. So you're kind of more restricted on the mortgage backed securities to obviously real estate loans. In contrast, the ABS is usually backed by other sorts of financing, student loans, auto loans or credit card debt. Some financial sources do use ABS as a generic term encompassing any sort of securitized investment based on underlying asset pools in which case an MBS is a kind of ABS. Others consider ABS's and MBS's to be separate investment vehicles. So there could be some ambiguity in terms of the classifications between the two as you could see could be some crossover. In other words, you might say, well, an MBS is an ABS, but an ABS is not necessarily an MBS, right? So how does assets securitization work? Assets securitization begins when a lender or any company with loans or a firm with income producing assets earmarks a bunch of these assets and then arranges to sell the lot to an investment bank or other financial institution. This institution often pools these assets with comparable ones from other sellers, then establishes a special purpose vehicle, an SPV, an entity set up specifically to acquire the assets, package them and issue them as a single security. The issuer then sells these securities to investors, usually institutional investors, hedge funds, mutual funds, pension plans, et cetera. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the portfolio of assets. Sometimes the issuer divides the original asset portfolio into slices called tranches. Each tranche is sold separately and bears a different degree of risk indicated by a different credit rating.