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Trading and Capital-Markets Activities Manual

Instrument Profiles: Asset-Backed Securities and Asset-Backed Commercial Paper
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Asset-backed securities (ABS) are debt instruments that represent an interest in a pool of assets. Technically, mortgage-backed securities (MBS) can be viewed as a subset of ABS, but the term ''ABS'' is generally used to refer to securities in which underlying collateral consists of assets other than residential first mortgages such as credit card and home equity loans, leases, or commercial mortgage loans. Issuers are primarily banks and finance companies, captive finance subsidiaries of non-financial corporations (for example, GMAC), or specialized originators such as credit card lenders (for example, Discover). Credit risk is an important issue in asset-backed securities because of the significant credit risks inherent in the underlying collateral and because issuers are primarily private entities. Accordingly, asset-backed securities generally include one or more credit enhancements, which are designed to raise the overall credit quality of the security above that of the underlying loans. 

Another important type of asset-backed security is commercial paper issued by special-purpose entities. Asset-backed commercial paper is usually backed by trade receivables, though such conduits may also fund commercial and industrial loans. Banks are typically more active as issuers of these instruments than as investors in them. 

CHARACTERISTICS AND FEATURES 

An asset-backed security is created by the sale of assets or collateral to a conduit, which becomes the legal issuer of the ABS. The securitization conduit or issuer is generally a bankruptcy-remote vehicle such as a grantor trust or, in the case of an asset-backed commercial paper program, a special-purpose entity (SPE). The sponsor or originator of the collateral usually establishes the issuer. Interests in the trust, which embody the right to certain cash flows arising from the underlying assets, are then sold in the form of securities to investors through an investment bank or other securities underwriter. Each ABS has a servicer (often the originator of the collateral) that is responsible for collecting the cash flows generated by the securitized assets-principal, interest, and fees net of losses and any servicing costs as well as other expenses-and for passing them along to the investors in accord with the terms of the securities. The servicer processes the payments and administers the borrower accounts in the pool. 

The structure of an asset-backed security and the terms of the investors' interest in the collateral can vary widely depending on the type of collateral, the desires of investors, and the use of credit enhancements. Often ABS are structured to reallocate the risks entailed in the underlying collateral (particularly credit risk) into security tranches that match the desires of investors. For example, senior subordinated security structures give holders of senior tranches greater credit risk protection (albeit at lower yields) than holders of subordinated tranches. Under this structure, at least two classes of asset-backed securities are issued, with the senior class having a priority claim on the cash flows from the underlying pool of assets. The subordinated class must absorb credit losses on the collateral before losses can be charged to the senior portion. Because the senior class has this priority claim, cash flows from the underlying pool of assets must first satisfy the requirements of the senior class. Only after these requirements have been met will the cash flows be directed to service the subordinated class. 

ABS also use various forms of credit enhancements to transform the risk-return profile of underlying collateral, including third-party credit enhancements, recourse provisions, over-collateralization, and various covenants. Third-party credit enhancements include standby letters of credit, collateral or pool insurance, or surety bonds from third parties. Recourse provisions are guarantees that require the originator to cover any losses up to a contractually agreed-upon amount. One type of recourse provision, usually seen in securities backed by credit card receivables, is the ''spread account.'' This account is actually an escrow account whose funds are derived from a portion of the spread between the interest earned on the assets in the underlying pool of collateral and the lower interest paid on securities issued by the trust. The amounts that accumulate in this escrow account are used to cover credit losses in the underlying asset pool, up to several multiples of historical losses on the particular asset collateralizing the securities. 

Over-collateralization is another form of credit enhancement that covers a predetermined amount of potential credit losses. It occurs when the value of the underlying assets exceeds the face value of the securities. A similar form of credit enhancement is the cash-collateral account, which is established when a third party deposits cash into a pledged account. The use of cash-collateral accounts, which are considered by enhancers to be loans, grew as the number of highly rated banks and other credit enhancers declined in the early 1990s. Cash-collateral accounts provide credit protection to investors of a securitization by eliminating ''event risk,'' or the risk that the credit enhancer will have its credit rating downgraded or that it will not be able to fulfill its financial obligation to absorb losses. 

An investment banking firm or other organization generally serves as an underwriter for ABS. In addition, for asset-backed issues that are publicly offered, a credit-rating agency will analyze the policies and operations of the originator and servicer, as well as the structure, underlying pool of assets, expected cash flows, and other attributes of the securities. Before assigning a rating to the issue, the rating agency will also assess the extent of loss protection provided to investors by the credit enhancements associated with the issue. 

Although the basic elements of all asset-backed securities are similar, individual transactions can differ markedly in both structure and execution. Important determinants of the risk associated with issuing or holding the securities include the process by which principal and interest payments are allocated and down-streamed to investors, how credit losses affect the trust and the return to investors, whether collateral represents a fixed set of specific assets or accounts, whether the underlying loans are revolving or closed-end, under what terms (including maturity of the asset-backed instrument) any remaining balance in the accounts may revert to the issuing company, and the extent to which the issuing company (the actual source of the collateral assets) is obligated to provide support to the trust/conduit or to the investors. Further issues may arise based on discretionary behavior of the issuer within the terms of the securitization agreement, such as voluntary buybacks from, or contributions to, the underlying pool of loans when credit losses rise. 

A bank or other issuer may play more than one role in the securitization process. An issuer can simultaneously serve as originator of loans, servicer, administrator of the trust, underwriter, provider of liquidity, and credit enhancer. Issuers typically receive a fee for each element of the transaction. 

Institutions acquiring ABS should recognize that the multiplicity of roles that may be played by a single firm-within a single securitization or across a number of them-means that credit and operational risk can accumulate into significant concentrations with respect to one or a small number of firms. 

TYPES OF SECURITIZED ASSETS 

There are many different varieties of asset-backed securities, often customized to the terms and characteristics of the underlying collateral. The most common types are securities collateralized by revolving credit-card receivables, but instruments backed by home equity loans, other second mortgages, and automobile-finance receivables are also common. 

Installment Loans 

Securities backed by closed-end installment loans are typically the least complex form of asset-backed instruments. Collateral for these ABS typically includes leases, automobile loans, and student loans. The loans that form the pool of collateral for the asset-backed security may have varying contractual maturities and may or may not represent a heterogeneous pool of borrowers. Unlike a mortgage pass-through instrument, the trustee does not need to take physical possession of any account documents to perfect security interest in the receivables under the Uniform Commercial Code. The repayment stream on installment loans is fairly predictable, since it is primarily determined by a contractual amortization schedule. Early repayment on these instruments can occur for a number of reasons, with most tied to the disposition of the underlying collateral (for example, in the case of an ABS backed by an automobile loan, the sale of the vehicle). Interest is typically passed through to bondholders at a fixed rate that is slightly below the weighted average coupon of the loan pool, allowing for servicing and other expenses as well as credit losses. 

Revolving Credit 

Unlike closed-end installment loans, revolving credit receivables involve greater uncertainty about future cash flows. Therefore, ABS structures using this type of collateral must be more complex to afford investors more comfort in predicting their repayment. Accounts included in the securitization pool may have balances that grow or decline over the life of the ABS. Accordingly, at maturity of the ABS, any remaining balances revert to the originator. During the term of the ABS, the originator may be required to sell additional accounts to the pool to maintain a minimum dollar amount of collateral if accountholders pay down their balances in advance of predetermined rates. 

Credit card securitizations are the most prevalent form of revolving-credit ABS, although home equity lines of credit are a growing source of ABS collateral. Credit card ABS are typically structured to incorporate two phases in the life cycle of the collateral: an initial phase during which the principal amount of the securities remains constant, and an amortization phase during which investors are paid off. A specific period of time is assigned to each phase. Typically, a specific pool of accounts is identified in the securitization documents, and these specifications may include not only the initial pool of loans but a portfolio from which new accounts may be contributed. 

The dominant vehicle for issuing securities backed by credit cards is a master-trust structure with a ''spread account,'' which is funded up to a predetermined amount through ''excess yield''-that is, interest and fee income less credit losses, servicing, and other fees. With credit card receivables, the income from the pool of loans-even after credit losses-is generally much higher than the return paid to investors. After the spread account accumulates to its predetermined level, the excess yield reverts to the issuer. Under GAAP, issuers are required to recognize on their balance sheet an excess yield asset that is based on the fair value of the expected future excess yield; in principle, this value would be based on the net present value of the expected earnings stream from the transaction. Issuers are further required to revalue the asset periodically to take account of changes in fair value that may occur due to interest rates, actual credit losses, and other factors relevant to the future stream of excess yield. The accounting and capital implications of these transactions are discussed further below. 

Asset-Backed Commercial Paper 

A number of larger banks have started using a new structure, a ''special-purpose entity (SPE),'' which is designed to acquire trade receivables and commercial loans from high-quality (often investment-grade) obligors and to fund those loans by issuing (asset-backed) commercial paper that is to be repaid from the cash flow of the receivables. Capital is contributed to the SPE by the originating bank which, together with the high quality of the underlying borrowers, is sufficient to allow the SPE to receive a high credit rating. The net result is that the SPE's cost of funding can be at or below that of the originating bank itself. The SPE is ''owned'' by individuals who are not formally affiliated with the bank, although the degree of separation is typically minimal. 

These securitization programs enable banks to arrange short-term financing support for their customers without having to extend credit directly. This structure provides borrowers with an alternative source of funding and allows banks to earn fee income for managing the programs. As the asset-backed commercial paper structure has developed, it has been used to finance a variety of underlying loans-in some cases, loans purchased from other firms rather than originated by the bank itself-and as a remote-origination vehicle from which loans can be made directly. Like other securitization techniques, this structure allows banks to meet their customers' credit needs while incurring lower capital requirements and a smaller balance sheet than if it made the loans directly. 

USES 

Issuers obtain a number of advantages from securitizing assets, including improving their capital ratios and return on assets, monetizing gains in loan value, generating fee income by providing services to the securitization conduit, closing a potential source of interest-rate risk, and increasing institutional liquidity by providing access to a new source of funds. Investors are attracted by the high credit quality of ABS, as well as their attractive returns. 

DESCRIPTION OF MARKETPLACE 

The primary buyers for ABS have been insurance companies and pension funds looking for attractive returns with superior credit quality. New issues often sell out very quickly. Banks typically are not active buyers of these securities. The secondary market is active, but new issues currently trade at a premium to more seasoned products. 

Market transparency can be less than perfect, especially when banks and other issuers retain most of the economic risk despite the securitization transaction. This is particularly true when excess yield is a significant part of the transaction and when recourse (explicit or implicit) is a material consideration. The early-amortization features of some ABS also may not be fully understood by potential buyers. 

PRICING 

ABS carry coupons that can be fixed (generally yielding between 50 and 300 basis points over the Treasury curve) or floating (for example, 15 basis points over one-month LIBOR). Pricing is typically designed to mirror the coupon characteristics of the loans being securitized. The spread will vary depending on the credit quality of the underlying collateral, the degree and nature of credit enhancement, and the degree of variability in the cash flows emanating from the securitized loans. 

HEDGING 

Given the high degree of predictability in their cash flows, the hedging of installment loans and revolving-credit ABS holdings is relatively straightforward and can be accomplished either through cash-flow matching or duration hedging. Most market risk arises from the perceived credit quality of the collateral and the nature and degree of credit enhancement, a risk that may be difficult to hedge. One source of potential unpredictability, however, is the risk that acceleration or wind-down provisions would be triggered by poor credit quality in the asset pool- essentially, a complex credit-quality option that pays off bondholders early if credit losses exceed some threshold level. 

For issuers, variability in excess yield (in terms of carrying value) or in the spread account (in terms of income) can represent a material interest-rate risk, particularly if the bonds pay interest on a variable-rate basis while the underlying loans are fixed-rate instruments. While the risk can be significant, the hedging solutions are not complex (that is, dollar-for-dollar in notional terms). Potential hedging strategies include the use of futures or forwards, forward rate agreements (FRAs), swaps, or more complex options or swaptions. In the case of home equity loans or other revolving credits for which the pool earnings rate is linked to prime while the ABS interest rate is not, prime LIBOR swaps or similar instruments could be used to mitigate basis risk. Note that the presence of interest-rate risk may have credit-quality ramifications for the securities, since tighter excess yield and spread accounts would reduce the ability of the structure to absorb credit losses. 

An asset-backed commercial paper (ABCP) program can lead to maturity mismatches for the issuer depending on the pricing characteristics of the commercial loan assets. Similarly, the presence of embedded options-such as prepayment options, caps, or floors-can expose the ABCP entity to options risk. These risks can be hedged through use of options, swaptions, or other derivative instruments. As with home equity ABS, prime-based commercial loans could lead to basis-risk exposure, which can be hedged using basis swaps. 

RISKS 

Credit Risk Credit risk arises from (1) losses due to defaults by the borrowers in the underlying collateral and (2) the issuer's or servicer's failure to perform. These two elements can blur together as, for example, in the case of a servicer who does not provide adequate credit-review scrutiny to the serviced portfolio, leading to a higher incidence of defaults. ABS are rated by major rating agencies. 

Market Risk Market risk arises from the cash-flow characteristics of the security, which for most ABS tend to be predictable. Rate-motivated prepayments are a relatively minor phenomenon due to the small principal amounts on each loan and the relatively short maturity. The greatest variability in cash flows comes from credit performance, including the presence of wind-down or acceleration features designed to protect the investor in the event that credit losses in the portfolio rise well above expected levels. 

Interest-Rate Risk Interest-rate risk arises for the issuer from the relationship between the pricing terms on the underlying loans and the terms of the rate paid to bondholders, and from the need to mark to market the excess servicing or spread-account proceeds carried on the balance sheet. For the holder of the security, interest-rate risk depends on the expected life or repricing of the ABS, with relatively minor risk arising from embedded options. The notable exception is valuation of the wind-down option. 

Liquidity Risk Liquidity risk can arise from increased perceived credit risk, like that which occurred in 1996 and 1997 with the rise in reported delinquencies and losses on securitized pools of credit cards. Liquidity can also become a major concern for asset-backed commercial paper programs if concerns about credit quality, for example, lead investors to avoid the commercial paper issued by the special-purpose entity. For these cases, the securitization transaction may include a ''liquidity facility,'' which requires the facility provider to advance funds to the SPE if liquidity problems arise. To the extent that the bank originating the loans is also the provider of the liquidity facility, and that the bank is likely to experience similar market concerns if the loans it originates deteriorate, the ultimate practical value of the liquidity facility to the transaction may be questionable. 

Operations Risk 

Operations risk arises through the potential for misrepresentation of loan quality or terms by the originating institution, misrepresentation of the nature and current value of the assets by the servicer, and inadequate controls over disbursements and receipts by the servicer. 

ACCOUNTING TREATMENT 

The Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,'' determines the accounting treatment for investments in government agency securities. SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

For the holder of ABS, a 100 percent risk weighting is assigned for corporate issues and a 20 percent rating for state or municipal issues. Under risk-based capital regulations, a transfer of assets is a ''true sale'' as long as the banking organization (1) retains no risk of loss and (2) has no obligation to any party for the payment of principal or interest on the assets transferred. Unless these conditions are met, the banking organization is deemed to have sold the assets with recourse; thus, capital generally must be held against the entire risk-weighted amount of the assets sold unless (1) the transaction is subject to the low-level-capital rule or (2) the loans securitized are small business loans and receive preferential treatments. Assets sold in which an interest-only receivable is recognized under SFAS 125, or in which the spread account is recognized on the balance sheet and provides credit enhancement to the assets sold, are deemed to have been sold with recourse. In the case of asset-Asset-Backed Securities and Asset-Backed Commercial Paper 4105.1 Trading and Capital-Markets Activities Manual April 2001 Page 5 backed commercial paper, capital generally must be held against the entire risk-weighted amount of any guarantee, other credit enhancement, or liquidity facility provided by the bank to the special-purpose entity. 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Asset-backed securities can be either type IV or type V securities. Type IV securities were added as bank-eligible securities in 1996 primarily in response to provisions of the Riegle Community Development and Regulatory Improvement Act of 1994 (RCDRIA), which removed quantitative limits on a bank's ability to buy commercial mortgage and small-business-loan securities. In summary, type IV securities include the following asset-backed securities that are fully secured by interests in a pool (or pools) of loans made to numerous obligors: 

  investment-grade residential-mortgage-related securities offered or sold pursuant to section 4(5) of the Securities Act of 1933 (15 USC 77d(5)) 
  residential-mortgage-related securities as described in section 3(a)(41) of the Securities Exchange Act of 1934, (15 USC 78c(a)(41)) that are rated in one of the two highest investment-grade rating categories 
  investment-grade commercial mortgage securities offered or sold pursuant to section 4(5) of the Securities Act of 1933 (15 USC 77d(5)) 
  commercial mortgage securities as described in section 3(a)(41) of the Securities Exchange Act of 1934 (15 USC 78c(a)(41)) that are rated in one of the two highest investment-grade rating categories 
  investment-grade, small-business-loan securities as described in section 3(a)(53)(A) of the Securities Exchange Act of 1934 (15 USC 78c(a)(53)(A)) 

For all type IV commercial and residential mortgage securities and for type IV small-business-loan securities rated in the top two rating categories, there is no limitation on the amount a bank can purchase or sell for its own account. Type IV investment-grade small-business-loan securities that are not rated in the top two rating categories are subject to a limit of 25 percent of a bank's capital and surplus for any one issuer. In addition to being able to purchase and sell type IV securities, subject to the above limitations, a bank may deal in those type IV securities which are fully secured by type I securities. 

Type V securities consist of all ABS that are not type IV securities. Specifically, they are defined as marketable, investment-grade-rated securities that are not type IV and are ''fully secured by interests in a pool of loans to numerous obligors and in which a national bank could invest directly.'' They include securities backed by auto loans, credit card loans, home equity loans, and other assets. Also included are residential and commercial mortgage securities as described in section 3(a)(41) of the Securities Exchange Act of 1934 (15 USC 78c(a)(41)) which are not rated in one of the two highest investment-grade rating categories, but are still investment grade. A bank may purchase or sell type V securities for its own account provided the aggregate par value of type V securities issued by any one issuer held by the bank does not exceed 25 percent of the bank's capital and surplus. 

REFERENCES 

 SR-97-21, ''Risk Management and Capital Adequacy of Exposures Arising from Secondary-Market Credit Activities.'' July 1997. 
 SR-96-30, ''Risk-Based Capital Treatment of Asset Sales with Recourse.'' November 1996. 
 SR-92-11, ''Asset-Backed Commercial Paper Programs.'' April 1992. 
 Dierdorff, Mary D., and Annika Sandback. ''ABCP Market Overview: 1996Was Another Record-Breaking Year.'' Moody's Structured Finance Special Report. 1st Quarter 1997. 
 Kavanaugh, Barbara, Thomas R. Boemio, and Gerald A. Edwards, Jr. ''Asset-Backed Commercial Paper Programs.'' Federal Reserve Bulletin. February 1992, pp. 107-116. 
 Moody's Structured Finance Special Report. ''More of the Same. . .or Worse? The Dilemma of Prefunding Accounts in Automobile Loan Securitizations." August 4, 1995. 
 Rosenberg, Kenneth J., J. Douglas Murray, and Kathleen Culley. ''Asset-Backed CP's New Look.'' Fitch Research Structured Finance Special Report. August 15, 1994. 
 Silver, Andrew A., and Jay H. Eisbruck. ''Credit Card Master Trusts: The Risks of Account Additions.'' Moody's Structured Finance Special Report. December 1994. 
 Silver, Andrew A., and Jay H. Eisbruck. ''Credit Card Master Trusts: Assessing the Risks of Cash Flow Allocations.'' Moody's Structured Finance Special Report. May 26, 1995.
 Stancher, Mark, and Brian Clarkson. ''Credit Card Securitizations: Catching Up with Wind-Downs.'' Moody's Structured Finance Special Report. November 1994. 
 van Eck, Tracy Hudson. ''Asset-Backed Securities.'' In The Handbook of Fixed Income Securities. Fabozzi, F., and T.D. Fabozzi. Chicago: Irwin Professional Publishers, 1995. Asset-Backed Securities and Asset-Backed Commercial Paper 4105.1

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