With the addition of the Volker Rule being added to the mix, now seems like the right time to explore the differences and similarities between asset-backed securities (ABS) and mortgage-backed securities (MBS).
Mortgage-backed securities are derived from the pooling of mortgages which are then sold to groups of investors. Assetbacked securities, on the other hand, are created from the pooling of loans on some non-mortgage assets. Asset-backed securities are typically backed by credit card receivables, home equity loans, student loans and auto-loans.
The similarities in the two investment options come in around the structuring of the parties involved; both have sellers, issuers and investors involved in their transaction structures. Sellers are made up of companies that generate loans and sell them to issuers. Sellers also hold the responsibility of acting as the servicer, colleting principal and interest payments from the borrowers. Issuers buy loans from sellers and then pool them together, creating opportunities for ABS or MBS investors.
Both options benefit sellers since, once the ABS or MBS has been created, they can be removed from the balance sheet, allowing sellers to acquire additional funding. Essentially this action allows a nondepository mortgage bank selling the loan to simultaneously pay off its warehouse line, making them more fluid with funds needed to continue mortgage related activities.
Both options have pre-payment risks; meaning the risk of borrowers paying more than their required monthly payments, refinance the loan balance entirely or default on payments, which would thereby reduce the interest of the loan. Loan default includes the added risk of loan loss dependent upon the asset value and loan balance at the time of default. This risk is especially high with mortgage-backed securities and lesser with asset-backed securities.
To help with these risks, both options have tranching structures in place which distribute pre-payment risks among the tranches. Investors have the option of investing in whichever tranch they feel best meets their own personal preferences and risk tolerance. As a rule of thumb, subordinate tranches have a higher yield than senior tranches.
When evaluating which option is best for investing, investors will want to review and measure the spread and pricing of bond securities. If the security doesn’t have embedded options, the zero-volatility spread can be used as a form or measurement. As a constant spread, the zero-spread makes the price of a security equal to the present value of its cash flow.
The overall process of creating ABS and MBS pools is very complicated because they are sliced and mingled based on risk, characteristics and a variety of complex factors, making the structures highly complicated in terms of valuations. Investors should be careful to match their risk tolerance, just as underwriting does in primary markets.
Marcus McCue |
EVP & CBDO