23.5.3 Types of Asset-Backed Securities

Introduction

The world of structured finance includes various financial instruments designed to transfer risk and repackage assets. Among these are Asset-Backed Securities (ABS), which pool together cash-generating assets to create securities sold to investors. This article covers the critical types of ABS, including Mortgage-Backed Securities (MBS), Collateralized Debt Obligations (CDOs), and securities backed by auto loans and credit card receivables.

23.5.3 Types of Asset-Backed Securities

Mortgage-Backed Securities (MBS)

Mortgage-Backed Securities (MBS) are a type of ABS specifically backed by mortgages, either residential or commercial. These securities represent an interest in a pool of mortgage loans, providing liquidity to the mortgage market.

Key Features:

• Residential MBS (RMBS): Backed by residential mortgage loans, RMBS are typically issued by government agencies or authorized financial entities.
• Commercial MBS (CMBS): These are backed by commercial properties, such as office buildings or shopping malls, and involve larger pools with more complex structures.

Benefits:

• Diversification: By pooling together numerous mortgages, MBS spreads risk across many borrowers.
• Liquidity and Accessibility: MBS offers a way for more investors to gain exposure to the mortgage market.

Below is a simplified flow of how Mortgage-Backed Securities are structured:

    graph TD;
	    A[Borrowers] -->|Pays Mortgage| B[Mortgage Lender];
	    B -->|Sells Pool| C[Securitization Entity];
	    C -->|Issues| D[Mortgage-Backed Securities];
	    D -->|Bought by| E[Investors];

Collateralized Debt Obligations (CDOs)

Collateralized Debt Obligations (CDOs) involve the pooling of various debt securities into a single investment vehicle. CDOs may include corporate bonds, loans, and even portions of other ABS or MBS.

Key Features:

• Diverse Collateral: CDOs can contain a mix of assets, providing investment diversity.
• Tranching: They are structured into different risk levels or tranches, offering tiers of interest payments and principal protection.

Risks:

• Complexity: The inherent complexity makes CDOs suitable mostly for sophisticated investors.
• Market Sensitivity: They can be sensitive to market conditions, particularly if underlying assets default on payments.

Auto Loans and Credit Cards

Securities backed by auto loans and credit card receivables form another segment of the Asset-Backed Securities market. These are unique because they offer short to medium-term investment opportunities.

Key Features:

• Auto Loan ABS: Based on pools of auto loans, these are typically less risky, with predictable payment patterns.
• Credit Card ABS: These are secured by the receivables generated from credit card debt, providing returns through interest and fees collected.

Benefits:

• Shorter Maturity: These ABS types generally have shorter durations than MBS, reducing exposure to long-term market risks.
• Predictable Cash Flow: The structured payment schedules make them predictably cash-flow-positive, appealing for income-focused investors.

Glossary

• Asset-Backed Securities (ABS): A financial security backed by a pool of assets, such as loans or receivables.
• Tranching: The process of segmenting a security offering into tiers with varying levels of risk and return.

Additional Resources

1. The Handbook of Mortgage-Backed Securities by Frank J. Fabozzi, a comprehensive guide to understanding MBS.
2. Collateralized Debt Obligations: Structures and Analysis by Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi.

Summary

In this section of the Canadian Securities Course, we’ve explored the diverse types of asset-backed securities, each serving a unique purpose and financial niche. From Mortgage-Backed Securities offering access to real estate-backed assets, CDOs providing complex yet diversified investment options, to more accessible securities backed by auto loans and credit cards, ABS are vital instruments for spreading risk and gaining exposure to various parts of the credit market. With these understandings, investors can better navigate the intricacies of structured products and make informed financial decisions.