Defining Asset-Backed (ABS) and Mortgage-Backed Securities (MBS)

Asset-backed securities (ABS) and mortgage-backed securities (MBS) are two of the most important types of asset classes within the fixed-income sector. MBS are created from the pooling of mortgages that are sold to interested investors, whereas ABS is created from the pooling of non-mortgage assets. These securities are usually backed by credit card receivables, home equity loans, student loans, and auto loans. The ABS market was developed in the 1980s and has become increasingly important to the U.S. debt market. Despite their apparent similarities, the two types of assets possess key differences.

The structure of these types of securities are based on three parties: the seller, the issuer, and the investor. Sellers are the companies that generate loans for sale to issuers and act as the servicer, collecting principal and interest payments from borrowers. ABS and MBS benefit sellers because they can be removed from the balance sheet, allowing sellers to acquire additional funding.

Issuers buy loans from sellers and pool them together to release ABS or MBS to investors, and can be a third-party company or special-purpose vehicle (SPV). Investors of ABS and MBS are typically institutional investors that use ABS and MBS in an attempt to obtain higher yields than government bonds and provide diversification.

There are many types of ABS, each with different characteristics, cash flows and valuations. Here are some of the most common ABS types:

Home Equity ABS: Home equity loans are very similar to mortgages, which in turn makes home equity ABS similar to MBS. The major difference between home equity loans and mortgages is that the borrowers of a home equity loan typically do not have good credit ratings, which is why they were unable to receive a mortgage. Therefore, investors need to review borrowers' credit ratings when analyzing home equity loan-backed ABS.

Auto Loan ABS: Auto loans are types of amortizing assets, and so the cash flows of an auto loan ABS include monthly interest, principal payment, and prepayment. Prepayment risk for an auto loan ABS is much lower when compared to a home equity loan ABS or MBS. Prepayment only happens when the borrower has extra funds to pay the loan. Refinancing is rare when the interest rate falls because cars depreciate faster than the loan balance, resulting in the collateral value of the car being less than the outstanding balance. The balances of these loans are normally small and borrowers won't be able to save significant amounts from refinancing at a lower interest rate, giving little incentive to refinance.

Credit Card Receivable ABS: Credit card receivables are a type of non-amortizing asset ABS. They don't have scheduled payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees. There is usually a lock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the lock-up period, the principal payment is passed on to ABS investors.

Most mortgage-backed securities are issued by Ginnie Mae (the Government National Mortgage Association), Fannie Mae (the Federal National Mortgage Association) or Freddie Mac (the Federal Home Loan Mortgage Corporation), which are all U.S. government-sponsored enterprises.

MBS from Ginnie Mae are backed by the full faith and credit of the U.S. government, which guarantees that investors receive full and timely payments of principal and interest. In contrast, Fannie Mae and Freddie Mac MBS are not backed by the full faith and credit of the U.S. government, but both have special authority to borrow from the U.S. Treasury if necessary.

Mortgage-backed securities can be purchased at most full-service brokerage firms and some discount brokers. The minimum investment is typically $25,000; however, there are some MBS variations (collateralized mortgage obligations, or CMOs) that can be purchased for less than $5,000. Investors that don't want to invest directly in a mortgage-backed security, but want exposure to the mortgage market may consider exchange-traded funds (ETFs) that invest in mortgage-backed securities such as the SPDR Barclays Mortgage Backed Bond ETF (MBG), the iShares MBS ETF (MBB), and the Vanguard Mortgage-Backed Securities Index ETF (VMBS). ETFs trade similar to stocks on regulated exchanges and can be sold short and purchased on margin. Like stocks, ETF prices fluctuate throughout each trading session in response to market events and investor activities.

It is important to measure the spread and pricing of bond securities and know the type of spread that should be used for different types of ABS and MBS. If the securities do not have embedded options such as call, put or certain prepayment options, the zero-volatility spread (Z-spread) can be used as a measurement. The Z-spread is the constant spread that makes the price of a security equal to the present value of its cash flow when added to each Treasury spot rate.

For example, we can use the Z-spread to measure credit card ABS and auto loan ABS. Credit card ABS does not have any options, making the Z-spread an appropriate measurement. Although auto loan ABS do have prepayment options, they're not typically exercised, making it possible to use the Z-spread for measurement.

If the security has embedded options, then the option-adjusted spread (OAS) should be used. The OAS is the spread adjusted for the embedded options. To derive the OAS, the binomial model can be used if cash flows depend on current interest rates but not on the path that led to the current interest rate.

Another way to derive the OAS is through the Monte Carlo model, which needs to be used when the cash flow of the security is the interest rate path dependent. MBS and Home Equity ABS are types of interest rate path-dependent securities where OAS from the Monte Carlo model would be used for valuations. However, this model can be quite complex and needs to be checked for accuracy throughout its usage.

Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS. Prepayment risk means borrowers are paying more than their required monthly payments, thereby reducing the interest of the loan. Prepayment risk can be determined by current and issued mortgage rate difference, housing turnover and mortgage rates. For instance, if a mortgage rate begins at 9%, drops to 4%, rises to 10% and then falls to 5%, homeowners would likely refinance their mortgages the first time the rates dropped. Therefore, to deal with prepayment risk, ABS and MBS have tranching structures to help distribute prepayment risk. Investors can choose a tranche based on their own preferences and risk tolerance.

One additional type of risk involved in ABS is credit risk. ABS has a senior-subordinate structure to deal with credit risk called credit tranching. The subordinate or junior tranches will absorb all of the losses up to their value before senior tranches begin to experience losses. Subordinate tranches typically have higher yields than senior tranches due to the higher risk incurred.

Asset-backed and mortgage-backed securities can be quite complicated in terms of their structures, characteristics, and valuations. Investors have access to these securities through indexes such as the U.S. ABS index. For those who want to invest in ABS or MBS directly, it's imperative to conduct a thorough amount of research and weigh your risk tolerance prior to making any investments.