Asset-Backed Securities (abs) vs Mortgage-Backed Securities (MBS)

Asset-Backed Securities (abs) vs Mortgage-Backed Securities (MBS): An Overview

Asset-backed securities (ABS) and mortgage-backed securities (MBS) are the two most important asset classes in the fixed income industry. Mortgage-backed securities are made up of mortgage loans issued to interested investors, while asset-backed securities are made up of non-collateralized assets. These securities are typically backed by credit card receivables, home equity loans, student loans, and auto loans. The asset-backed securities market developed in the 1980s and has grown in importance to the US debt market. While these two asset classes have obvious similarities, they have key differences.

The structure of these securities is based on three parties: the seller, the issuer, and the investor. A seller is a company that provides a sale loan to an issuer, acting as a service, collecting principal and interest from the borrower. Asset-backed securities and mortgage-backed securities are good for sellers because they can be removed from the balance sheet, allowing the seller to access additional funds.

Issuers buy loans from sellers and pool those loans to issue asset-backed securities (ABS) or mortgage-backed securities (MBS) to investors, which can be third-party companies or special purpose vehicles (SPVs). Investors in ABS and MBS are typically institutional investors who use ABS and MBS in an attempt to obtain higher yields than ** bonds and provide diversification.

key takeaways

  • Asset-backed securities (ABS) are created by pooling together non-collateralized assets such as student loans. Mortgage-backed securities (MBS) are a collection of mortgage loans. 
  • Asset-backed securities and mortgage-backed securities are good for sellers because they can be removed from the balance sheet, allowing the seller to access additional funds.
  • Both asset-backed securities and mortgage-backed securities have prepayment risks, although these risks are especially pronounced in mortgage-backed securities. 
  • Asset-backed securities companies also have credit risk, and they use advanced sub-structures (called credit tranches) to deal with the risk.
  • Valuation of ABS and MBS can be done through a variety of methods, including zero volatility and option-adjusted spreads. 

Asset-backed securities

There are many types of asset-backed securities, each with different characteristics, cash flows, and valuations. Below are some of the most common types. 

Home Equity Asset-Backed Securities

Home equity loans are very similar to mortgages, which in turn makes home equity asset-backed securities similar to mortgage-backed securities. The main difference between a home equity loan and a mortgage is that home equity loan borrowers usually don’t have a good mortgage credit rating, which is why they can’t get a mortgage. Therefore, investors need to review the credit rating of the borrower when analyzing asset-backed securities backed by home equity loans.

car loan abs

Auto loans are a type of amortizing asset, so auto loan ABS cash flows include monthly interest, principal payments, and prepayments. Auto loan ABS has a much lower prepayment risk than home equity loan ABS or mortgage-backed securities. Early repayments are only possible if the borrower has additional funds to pay the loan.

Refinancing is rare when interest rates are falling because the value of the car is depreciating faster than the balance loan, causing the car’s mortgage value to fall below the outstanding balance. The balances on these loans are often small, and borrowers can’t save a lot of money from lower-rate refinancing, so there’s little incentive to refinance.

Credit card receivable

Credit card receivables are non-amortizing asset ABS. They have no planned payment amounts, and new loans and changes can be added to the composition of the pool. Cash flow from credit card receivables includes interest, principal, and annual fees.

Credit card receivables usually have a lock-in period with no principal payment. If the principal is paid during the lock-up period, a new loan will be added to the ABS with the principal paid, leaving the pool of credit card receivables unchanged. After the lock-up period, the principal will be transferred to the ABS investor.

Mortgage-backed securities

Most mortgage-backed securities are issued by Ginny Mae (**National Mortgage Association), Fannie Mae (Federal National Mortgage Association), or Freddie Mac (Federal Home Loan Mortgage Corporation), which are sponsored by US** enterprise. 

Kinney’s mortgage-backed securities are backed by the full trust and credit of the U.S. government, which guarantees that investors will receive full principal and interest promptly. By contrast, Fannie Mae and Freddie Mac’s mortgage securitizations are not fully trusted and backed by the U.S. government, but both companies have special authority to borrow from the U.S. Treasury when necessary.

Mortgage-backed securities can be purchased at most full-service brokerages and some discount brokerages. The minimum investment is usually $10,000; however, there are some variations on mortgage securities, such as mortgage-backed obligations (CMOS), that can be purchased for less than $5,000. Investors who do not want to invest directly in mortgage-backed securities, but would like to invest in the mortgage market, can consider exchange-traded funds (ETFs) that invest in mortgage-backed securities.

Notable ETFs that invest in MBS include the iShares MBS ETF (MBB) and the Vanguard Mortgage-Backed Securities Index ETF (VMBS). ETFs trade like stocks on regulated exchanges and can be sold short or bought on margin. Like stocks, ETF prices fluctuate each trading day with market events and investor activity.

special attention items

Both asset-backed securities and mortgage-backed securities have prepayment risks, although these risks are especially pronounced in mortgage-backed securities. Prepayment risk means borrowers make more monthly payments than required, reducing interest on the loan. Prepayment risk can be determined by the difference between current and outstanding mortgage rates, housing turnover, and mortgage rates.

For example, if a mortgage rate starts at 9%, drops to 4%, rises to 10%, and then drops to 5%, homeowners may refinance their mortgage the first time the rate drops. Therefore, to address prepayment risk, asset securitization and mortgage securitization use a tranche structure to help distribute prepayment risk. Investors can choose shares according to their preferences and risk tolerance.

Another risk involved in asset securitization is credit risk. ABS has a high-level-subordinate structure that deals with credit risk, called credit tranches. Before the senior tranche begins to suffer losses, the secondary tranche or sub-tranches will absorb all losses up to their value. Subordinated bonds typically have higher yields than senior bonds due to their higher risk. 

The structure, characteristics, and valuation of asset-backed securities and mortgage-backed securities can be quite complex. Investors can access these securities through indices such as the US ABS Index. For those who want to invest directly in ABS or MBS, it is imperative to do thorough research and weigh your risk tolerance before making any investment.

ABS and MBS example

It is important to measure the spread and pricing of bond securities and to understand the types of spreads that should be used for different types of asset-backed and mortgage-backed securities. A zero volatility spread (Z-spread) can be used as a measure of the security that has no embedded options, such as calls, puts, or certain prepayment options. The Z-spread is a constant spread that makes the price of a security equal to the present value of its cash flows, plus the spot exchange rate for each Treasury bill. 

For example, we can use Z-spread to measure credit card ABS and auto loan ABS. Credit card ABS does not have any options to make Z-spread a proper measure. While auto loan ABS do have prepayment options, they are generally not exercised, making it possible to measure using the Z-spread.

If the security has embedded options, the option-adjusted spread (OAS) should be used. OAS is the spread adjusted for the embedded option. If the cash flow depends on the current interest rate rather than the path leading to the current interest rate, the binomial model can be used to derive the OAS. 

Another way to derive OAS is through a Monte Carlo model, which is needed when a security’s cash flows are related to the path of interest rates. Mortgage loan securitization and home equity securitization are interest rate path-dependent securities, and the OA in the Monte Carlo model will be used for valuation. However, this model can be quite complex and its accuracy needs to be checked throughout its use.

By Cary Grant

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