What are Asset Backed Securities?

In todays video we learn what are asset backed securities, what are credit card receivables and what is a Special Purpose Vehicle (SPV)?

Hello and welcome back to my youtube channel where i upload tutorials on quantitative finance and derivatives usually in short bite-size format to help people better understand important financial topics today we’re going to learn all about abs or asset-backed securities why they exist what they’re used for and how they’re structured okay so let’s get going on

Asset-backed securities this is video 2 in my series on credit derivatives and if you want to watch the whole series a link to the playlist is provided above ok so firstly let’s answer the question for our asset backed securities asset-backed securities also known as abs are bonds or notes backed by financial assets the asset pool is usually a group of small

And illiquid assets that would be difficult to sell on individually pooling these assets into financial instruments allows them to be sold to investors such as other banks hedge funds insurance companies and pension funds the pool of potential underlying assets is extensive it can include credit card receivables mortgage loans student loans auto loans trade

Receivables aircraft and other equipment leases royalty payments and even things like movie revenues when creating an asset-backed security the originating bank usually sets up a separate company called a special purpose vehicle to handle the securitization this separate company creates and sells two asset backed securities and uses the proceeds to pay back the

Bank that originated the underlying assets this is done to keep the asset backed security at arm’s length from the issuing bank such that if there are failures of the securities over time they remain separate from the performance and credit results of the bank that initially created them on screen right now you can see an image showing how an spv works this may look

Confusing at first but it’s just a diagram showing a corporate structure everything star the finance company on the left of the screen let’s imagine they’re a large company who has made lots of sales on credit and they have a large pool of receivables they’re customers who owed the money are highlighted in green the company raises money from investors shown on the

Right side of the slide who want to invest in these receivables that money is put into a new company the spv which in this example is called special purpose company it’s at the center of the slide they buy the assets from the company and as those receivables are collected the money will be passed back to the investors there may be a ratings agency which assesses the

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Quality of the assets for investors there may be a trustee who manages the spv and make sure everyone is being treated fairly there may even be a financial guarantee provider but as you can see the main purpose of this company is to hold the asset and to keep them separate from the originating company such that investors can invest in these specific assets without

Investing in the originating company that’s all in spv is so anyhow now that we know what an spv is the pools of assets are packaged into a tradable instrument whose value depends on the performance and cash flows of the underlying pool of individual assets once the assets have been packaged and transferred to the spv the originating bank can remove the assets from

Its own balance sheet receiving cash in return the asset backed securities are sold on to other financial institutions or investors this transaction often improves the credit rating of the originating bank as well as reduces the amount of regulatory capital that they are required to hold against there are other business activities the asset backed securities are

Usually rated by credit rating agencies and are evaluated based only on the assets and the liabilities of the spv this rating can be higher than the credit rating of the issuing bank as the risks of the asset backed securities are no longer associated with the other risks that the originating bank might bear this ring-fence thing can improve the credit rating of

The originating institution reducing the interest rate that it has to pay on its debt obligations so as an example of a bs let’s talk a little bit about credit card receivables securities backed by credit card receivables have been a key part of the abs market since they were first introduced in 1987 credit card holders may borrow funds on a revolving basis up

To an assigned credit limit the borrower’s then pay principal and interest as desired along with the required monthly minimum payment because principal payment is not scheduled credit card debt does not have an actual maturity date and is considered a non amortize alone the fact that credit card receivable securities are non amortized and uncollateralized are

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The key differentiators from other fixed income securities the process of securitizing credit card receivables is very similar to that of securitizing mortgages and other loan obligations a card issuer sells a group of accounts to a trust which issue securities backed by those receivables the card issuer still services the account but the assets are removed from

Its balance sheet this allows the card issuer to issue more accounts and to reduce its capital reserve requirements as the card holders pay on their accounts monthly most of the money is sent to the trust which pays the holders of the credit card a bs a–‘s interest and principal the card issuer retains a servicing fee and part of the finance charge as profit and

Also includes part of the principal the sellers interest securitization allows more rapid growth of banks specializing in credit card issuances by providing a source of funding and transferring risk before the securitization of credit card receivables credit card issuers borrowed money from a bank or relied on bank deposits to fund credit card loans securitization

Greatly expanded funding for credit card issuers including banks and issuers whose main business is not banking or issuing credit cards such as shale oil or amazon.com most credit card holders pay both principal and interest every month this income is used to pay bondholders but whether interest our principal is paid depends on the lifecycle period of the abs

Because the payment stream is highly variable most credit card abs have a revolving period and an amortization period so that an average maturity and an expected maturity day can be specified though not guaranteed during the revolving period investors receive interest payments only collections of principal are used to buy more receivables or to add to the seller

Interest although the principal and interest payments are highly variable over the term length of the sat bank security the seller interest grows or shrinks to keep the abs payments steady during the amortization period principal collections from card holders are used to repay the abs investors they’re invested principal during the amortization period principal

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Collections from card holders are used to repay the abs investors they’re invested principal during this final period the length of this period depends on the monthly payment rate from the card holders in the underlying portfolio if the card holders are paying less each month then the amortization period may be extended if payment rates are high then excess principal

Collections are used to buy more receivables some credit card abs is use controlled amortization making equal principal payments to investors over a specified time usually one year the amount of interest earned during the amortization period declines with the principal although the receivables vary over time the seller interest absorbs varying amounts to maintain a

Steady cash flow to the abs and some abs issues are structured so that the payments to investors are like bond payments where during the life of the abs investors receive equal interest payments with a final payment of interest and principal at majority this is accomplished by the use of a controlled accumulation period where principal collections are paid into and

Held in a trust account until maturity then the entire principal is paid out to the investors early amortization results when the credit profile of the abs security deteriorates because of problems with the seller or servicer or the collateral falls below an amount specified to maintain the credit rating of the security these problems constitute early amortization

Triggers which divert principal payments from the seller to the investors to repay them faster lessening their risk so now you know all about asset backed securities sp vs and credit card receivables and you’ll be able to impress your friends and family by discussing them over dinner this weekend all of these videos are based on my book which is linked to in the

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Transcribed from video
What are Asset Backed Securities? By Patrick Boyle

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