Asset-Backed Securities: The Kudos King

For finance professionals, understanding and securitising a pool of existing assets into an Asset-Backed Security (ABS) is a significant achievement. It creates value for an organisation and enhances their knowledge and decision-making skills, making it a crucial aspect of their treasury-related resumes. 

In corporate finance, ABS is not just a financial tool, it's a strategic move that can generate value on a grand scale, making it a crucial aspect of your professional toolkit.

In this article, we cover the following:

• What is an ABS?

• What are the benefits? 

• What are the risks? How can they be mitigated?

• Recommendations

The Basics

An ABS is a financing technique that effectively creates an asset (i.e. marketable securities) from a book of illiquid assets. The ABS is collateralised by the underlying pool of assets, which generally generates cash flow, such as mortgages, loans, leases, and receivables. It takes the form of a bond or note and pays income to the investors over a fixed amount of time. Some pools of assets are constantly changing and require proactive risk management to stay on policy, these are often referred to as ‘warehouses’. Term ABSs have a fixed pool of assets.

ABS is a versatile financing technique that can securitise a wide range of assets, not just Mortgage-Backed Securities (MBS). Toll roads, movie revenues, and aircraft landing slots are just a few examples.. Here is a diagrammatic presentation of the cash flows:

The bank would be the Seller of the assets and provide mortgages (goods and services) to its customers, who are obligated to make regular payments. The assets are then pooled together and sold to the SPV (Special Purpose Vehicle), which will fund the purchase of the pool of assets by issuing debt instruments to Investors. Credit rating agencies are used to obtain credit ratings on the debt instruments to satisfy the investor requirements and achieve optimal pricing.

The Benefits

Issuing ABSs is one way to raise capital for investment purposes and is often a cheaper form of funding. The individual illiquid assets can't be sold on their own. Still, by securitising them (pooling them together), the Seller of the assets can generate additional capital - think 2 + 2 = 5, but add lots of zeros to the equation. Furthermore, ABS can create significant capital relief by removing risky assets from the balance sheet. This has the added benefit of improving the Sellers' credit risk score. From the Investors' perspective, these securities are viewed as low-risk due to their structure and high credit rating status.

Risks

Of course, we should mention the risks of issuing mortgages to subprime borrowers. In 2007, the catalyst for the GFC was the underperformance of the assets sold to Investors in an MBS. Lax lending standards contributed to the real-estate bubbles that burst in the US and elsewhere, and the vehicle of securitisation enabled the lenders to pass on the risks to Investors. Many corporates immediately banned MBS until more regulation was in place.  Nowadays, the credit rating of the debt instrument depends on the credit quality of the assets and the credit and liquidity support provided to the SPV. 

Other risk management tools include hedging the interest rate risk within the SPV. Floating interest rate obligations to pay interest to investors should be hedged, especially if most of your assets only receive interest at fixed rates. Trustees will generally not accept unhedged positions. Hedging huge positions will increase your accounting volatility and must be managed with a hedge accounting program. There will be a lot more hedging activity in warehouses than a term ABS.

Getting the strategy across these risk management techniques aligned and tested with an expert is crucial to avoid unwanted accounting volatility and impacts on the NIM. 

Recommendations

When it comes to ABS transactions, you shouldn't do it alone. The key is to leverage your internal team as much as possible. By bringing people with you outside the project, you can upskill and reduce the key-man risk for future deals, fostering a culture of collaboration and shared knowledge.

Level up your support with experts in the field who can add value across all areas of the deal. This especially holds true when negotiating hedging terms, which are often left late in the piece when leverage has been lost. Make this one of the critical milestones and discuss it early with the financiers.

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