Quintessential Considerations — Asset Backed Securities (ABS)

Simplified illustration of an ABS

What is an Asset Backed Security?

At a high level, an ABS is a financial instrument with an underlying financial asset, sold by an issuer to an investor and even traded on a secondary market. An ABS can take on multiple forms, interesting structures and diversified risk profiles, but here are the main learnings for you to focus on:

1. As the name suggests, this is a financial instrument or a tradable ‘security’, collateralized or ‘backed’ by an asset. In this case, an asset is defined as a financial obligation that generates a future cashflow. The first thought this triggers is probably a loan — for example, you are purchasing a home and taking out a mortgage. This mortgage is considered an asset, and your monthly principal and interest payments are the future cashflows. So, yes — gym memberships, aircraft leases, toll road fees, AT&T mobile bills, auto loans — you name it, it has probably been securitized since there are recurring, and fairly predictable financial cashflows generated by it.
2. The process of securitization essentially bundles up said assets with future cashflows into one giant pie, and then sells slices of that pie to investors like banks, asset managers, and hedge funds. This process of pooling is known as securitization as it creates a financial security out of just a simple recurring cashflow like your Spotify subscription. Every month or payment period, a stream of cash is generated from the asset — for example, $15.99 for a Spotify family plan — which flows straight from you to the investors, following a pre-specified contractual order.
3. So, why would someone go through this process? Mortgage lenders can keep those assets for themselves and receive those future interest payments. Miramax securitized the royalties received from movies like Pulp Fiction & Shakespeare in Love, but they could have kept the cash for themselves. The main reason is this — it allows the company to raise funding at a cheaper cost as compared to just taking out a loan. Even if a company has a poor corporate rating and is unable to get debt at affordable rates, it can use its assets to structure a security which offers a better rate because of embedded safety features.
4. So then, why would someone buy that securitized asset, along with taking on the related risk that the cashflow may not come in as expected? Investors are always seeking to diversify their exposure into different asset classes — while an individual airline equipment lease is not liquid and cannot be traded on the market, a pool of such leases can offer investors a chance to bet on a niche market. There are certainly risks involved because the performance of the security depends squarely on the performance of the underlying assets, but over time, plenty of structural features have been developed to protect an investor in case of a market recession. Depending upon their risk preferences, investors can choose a slice of the pie with more or less protection.
5. For those who are aware that a collapse of mortgage-backed securities triggered the ‘07–’08 recession, this may seem dangerous. However, regulators are also aware of the shortcomings of poor due diligence, and compounding impacts of risk during economic downturns. Under Regulation Asset Backed (RegAB), regulations require issuers to keep at least 5% of the security to keep some skin in the game to ensure they are not selling poor quality assets under the guise of a safe security — an interesting way to align incentives. A third-party auditor is also usually involved in the structuring of the deal to ensure proper disclosures.

6 Through Infinity: Mechanics of an ABS, Corporate Finance Institute, Subscription ABS, Miramax ABS, Tranches, RegAB

The Quintessential Considerations series attempts to simplify the world of Finance, by highlighting the top 5 ideas you need to know about each concept. To dig in further, scroll to the bottom and navigate the links within “6 Through Infinity”. Check out my posts on Warehouse Lines of Credit here and Discounted Cash Flow Models here.