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By Arun Dahal Khatri
Understanding Asset-Backed Securities (ABS) and Mortgage-Backed Securities (MBS) can be challenging due to their complex structures and varying asset types. However, breaking down these securities can help clarify how they work and how investors can diversify their portfolios.
Asset-Backed Securities (ABS) Asset-backed securities are created by pooling non-mortgage assets, including credit card receivables, student loans, auto loans, and other types of consumer debt. The origin of ABS in the 1980s marked the beginning of a way for institutions to securitize loans unrelated to real estate. ABS allows businesses to remove these loans from their balance sheets and free up capital for additional lending. One common type of ABS is auto loans, which are bundled and sold to investors. Like most types of ABS, these loans are amortizing assets, meaning borrowers repay both interest and principal with each payment. Since car loans are relatively small and vehicles depreciate quickly, the risk of prepayment (when borrowers repay their loans early) is lower than in other forms of ABS or MBS.
Another popular form of ABS is credit card receivable ABS. Credit card debt is non-amortizing, meaning that, unlike auto loans, there is no fixed repayment schedule. Payments may include principal and interest, but no predetermined end dates exist. Credit card ABS often has a lock-up period, during which principal payments are not passed to investors. This characteristic makes credit card ABS more flexible, as new loans can be added to the pool, maintaining the overall balance.
Mortgage-Backed Securities (MBS) On the other hand, mortgage-backed securities are created by pooling mortgage loans sold to investors as securities. These are typically backed by the actual mortgages on real estate properties. MBS gained traction after the U.S. government created government-sponsored enterprises like Ginnie Mae, Fannie Mae, and Freddie Mac to facilitate homeownership by providing liquidity to the mortgage market. Ginnie Mae guarantees MBS, meaning they are backed by the full faith and credit of the U.S. government, making them relatively low-risk.
One unique feature of MBS is the prepayment risk, which is more pronounced in MBS than in ABS. Since mortgage borrowers can refinance or pay off their loans early, the principal and interest payments to investors may be reduced. For example, if mortgage rates drop from 9% to 4%, homeowners might refinance, and investors in MBS would receive their payments earlier, cutting down their expected returns. Critical Differences Between ABS and MBS While both ABS and MBS serve to pool assets and sell them to investors, their crucial difference lies in the underlying investments. ABS is backed by non-mortgage consumer loans, while MBS is strictly backed by mortgages. This fundamental distinction influences the risks associated with each type of security.
For example, home equity ABS resembles MBS but involves home equity loans, often given to borrowers with lower credit ratings. Because of the riskier nature of these loans, investors must carefully assess borrowers' credit ratings. This risk differs significantly from the general stability of traditional MBS backed by prime residential mortgages, particularly those guaranteed by Ginnie Mae. Another key difference is in the risk structure of ABS and MBS. While both asset classes can employ a system of tranching—where investors can choose between higher- and lower-risk portions of the securities—ABS tends to have an additional credit risk component. This credit risk is often managed using a senior-subordinate structure, credit tranching. In this structure, subordinate tranches absorb losses before senior tranches, meaning investors in senior tranches experience lower risk and lower yields, while subordinate tranches have higher yields due to the higher risk.
Valuing ABS and MBS Valuing ABS and MBS can be challenging because of the embedded options and prepayment risks. A standard method for valuing securities without embedded options, like credit card ABS, is the zero-volatility spread (Z-spread). This method adds a constant spread to the Treasury yield curve to calculate the present value of the security's cash flow. Since credit card ABS typically do not involve prepayment options, the Z-spread is an appropriate measure of their value.
On the other hand, for securities with embedded options like auto loans or MBS, the option-adjusted spread (OAS) is more appropriate. The OAS adjusts for the possibility of early repayment or refinancing. For example, in MBS, the OAS considers homeowners' likelihood to refinance their mortgage if interest rates drop, reducing the security value. The OAS can be calculated using complex models like the binomial model or the Monte Carlo simulation, which help investors evaluate how cash flows depend on the path of interest rates.
An example of the practical application of the Z-spread is auto loan ABS, where prepayment options exist but are rarely exercised due to cars' depreciating value. Thus, despite prepayment risk, the Z-spread is still effective for valuing these securities. In contrast, MBS are interest rate path-dependent, making the OAS a better tool for analyzing these types of assets.
Investment Considerations Both ABS and MBS are essential parts of the fixed-income market, allowing investors to diversify their portfolios beyond traditional bonds. With its various underlying assets, ABS provides flexibility and often higher yields than government bonds, though it comes with unique risks such as credit and prepayment risks. On the other hand, MBS offers a way to invest in the real estate market, often with the added security of government guarantees, as in the case of Ginnie Mae-backed MBS. Investors should consider their risk tolerance and investment objectives when deciding between ABS and MBS. Those looking for higher yields and willing to take on more risk might opt for subordinate tranches of ABS, which offer higher returns in exchange for absorbing losses. Conversely, conservative investors may prefer senior tranches of MBS, particularly those backed by government guarantees.
Conclusion Understanding ABS and MBS is essential for investors navigating the fixed-income market. While both types of securities pool assets to provide a steady income stream, they differ significantly in their underlying assets, risk structures, and valuation methods. By carefully considering these factors, investors can make informed decisions about incorporating ABS and MBS into their portfolios, taking advantage of their unique opportunities for diversification and yield enhancement.
This exploration of ABS and MBS highlights their complexity and potential as investment vehicles. Whether pooling credit card debt or residential mortgages, these securities are critical in the financial markets, enabling lenders to securitize their loans and investors to access a diverse range of income-generating assets.
References:
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