FI 18 Asset-Backed Security (ABS) Instrument and Market Features

Securitization funds a pool of assets, and those assets can take many forms: consumer and commercial loans, trade receivables, and residential or commercial mortgages. Whatever the collateral, the same idea sits underneath every asset-backed security (ABS). The cash flows thrown off by the pool are carved into several tranches, and each tranche is handed its own payment schedule and its own slice of the risk. This targeted partitioning dampens the variability that any single investor faces and pushes specific exposures, chiefly default and early repayment, onto the classes that agree to bear them in exchange for a matching return.

Seen from a distance, securitization delivers three things at once: it transfers risk, it gives issuers and investors flexibility in shaping exposures, and it uses capital more efficiently. This lesson works through three members of the ABS family. Covered bonds keep the collateral on the issuer’s own books. Non-mortgage ABS move a pool off the originator’s balance sheet, most often credit card receivables or solar loans. Collateralized debt obligations (CDOs) pool other debt instruments and are dominated in practice by the collateralized loan obligation (CLO).

Each deal is described in a term sheet. A term sheet reports the face value of the tranche notes as of the transaction date, the aggregate size of the collateral pool, and the conditions that would trigger early amortization. It does not report the market value of the notes, since that fluctuates after issuance and is not a fixed term of the deal.

A covered bond is a senior debt obligation issued by a financial institution and secured by a segregated pool of assets. That pool typically holds mortgages, commercial or residential, or else public-sector assets, though deals secured by ships and commercial aircraft exist too. The instrument is old: it began as the Pfandbrief in Prussia more than 250 years ago, and it is now issued across Europe, Asia, and Australia, with the European Union working to harmonize the rules across member states. Each jurisdiction sets its own list of eligible collateral and permitted structures.

The feature that separates a covered bond from an ordinary ABS is where the loans live. They remain on the issuer’s own books, ringfenced inside a distinct cover pool, instead of being sold off to an independent entity. That arrangement hands the investor two lines of recourse should the issuer fail. Recourse ranks first against the ringfenced cover-pool loans behind the deal, and then against whatever unencumbered assets the issuing bank still holds. Covered bonds that fund environmental projects, so-called green covered bonds, back their pools largely with mortgages on certified green buildings.

What keeps a covered bond safe

The cover pool is dynamic, not frozen. A third-party asset monitor checks the pool for performance and for adherence to the underwriting rules, and the issuer must swap out any asset that prepays or stops paying so that enough cash keeps flowing until the bond matures. Two further tools protect investors. First, the collateral backing the deal usually exceeds the face value of the bonds, a cushion called overcollateralization; Germany, for one, requires every cover pool to be overcollateralized to at least 2% above the economic value of the bonds outstanding, and some issuers add more of their own accord. Second, each mortgage must clear a loan-to-value (LTV) standard to enter the pool, and a mortgage that slips below the standard is replaced by one that meets it.

Redemption regimes

Redemption regimes exist to keep the bond’s cash flows as close as possible to the original schedule if the sponsor defaults. They come in three forms. A hard-bullet covered bond treats any payment that misses the original schedule as a default and accelerates the remaining payments at once. A soft-bullet covered bond postpones that default and acceleration to a new final maturity date, usually up to a year past the original date. A conditional pass-through covered bond instead converts into a pass-through security after the original maturity date whenever the scheduled payments have not all been made.

Taken together, dual recourse, strict eligibility, a dynamic pool, and these redemption regimes have made covered bonds a steady, dependable funding source. As a rule they carry lower credit risk and pay lower yields than an otherwise comparable ABS.

A covered bond normally has just one bond class per cover pool, so unlike a tranched ABS there is a single class of default exposure to manage.

The simplest securitization issues one class of notes. Return to the Bright Wheel Automotive (BRWA) deal, where the special purpose entity Car Loan Trust (CLT) raises EUR1,000 million by selling 1,000,000 certificates of a single Bond Class A, each with a par value of EUR1,000. Every certificate then entitles its holder to one one-millionth of the pool’s payments after servicing and administrative fees. In that plain structure the investor sits directly on top of the pool’s default risk. To soften that exposure, the entity can build a structure with several classes of ABS debt and apply credit enhancement, a form of financial backing that soaks up losses when the underlying loans default.

Internal credit enhancements

Three internal credit enhancements appear again and again. Overcollateralization sets the collateral value above the face value of the notes, so a run of defaults can be absorbed while principal and interest keep flowing. Excess spread is the gap between the coupon earned on the collateral and the coupon paid out on the securities; that surplus can cover shortfalls or build reserves. Subordination, also called credit tranching, splits the deal into senior and subordinated (junior or non-senior) classes that share losses in a set order. Because every investor is paid from one common pool of cash, the tranching fixes both the order of payment and the order in which losses land. External enhancements also exist, such as financial guarantees from banks or insurers, letters of credit, and cash collateral accounts, but the internal tools are the ones this reading develops.

Credit tranching and the waterfall

Subordination protects the senior classes because the junior classes take losses first. Payments cascade down the capital structure in what is called a waterfall. Suppose CLT now issues four classes totaling EUR1,000 million of par: Class A, the senior tranche, at EUR825 million; Class B, the mezzanine tranche, at EUR100 million; Class C, a junior tranche, at EUR50 million; and Class D, subordinated to everything else, at EUR25 million. Class A is paid first, bears the least risk, and pays the least. Class D absorbs losses first, bears the most risk, and can pay the most; because its claim is purely residual it is sometimes called the equity tranche.

Losses climb the ladder in order. Class D absorbs the first EUR25 million. Class C then absorbs the next EUR50 million, covering cumulative losses from EUR25 million to EUR75 million. Class B absorbs the following EUR100 million, from EUR75 million up to EUR175 million. Only when cumulative losses exceed EUR175 million, wiping out every junior class, does Class A begin to lose its EUR825 million.

Each class receives a risk rating that reflects both the credit quality of the pool and its own seniority in absorbing losses. The two subordinated classes rate as riskier than the senior class and carry wider credit spreads, with Class D wider than Class C. Because of collateralization and credit enhancement, some classes can even earn a better rating than the company raising the funds.

Plenty of assets besides mortgages get securitized: auto loans, credit card receivables, personal loans, trade receivables, and commercial loans. A useful first split is whether the collateral amortizes. In an amortizing pool, such as traditional residential mortgages or auto loans, each periodic payment carries both interest and principal, so scheduled principal and any prepayments pass through to the classes and the pool steadily shrinks as loans mature.

A non-amortizing pool, such as credit card debt, has no scheduled principal repayments. When a borrower does repay principal during the lockout or revolving period, that cash is reinvested to buy additional loans of equal principal, which replenishes the pool and holds its size roughly constant. Once the lockout period ends, the amortization period begins and repaid principal is no longer reinvested; instead it is distributed to the ABS holders.

Credit card receivable ABS

A credit card purchase creates a receivable for the lender, and pooled receivables become the collateral for a credit card ABS. Issuers gain three ways from securitizing them: the receivables leave the balance sheet, which improves capital efficiency and lowers funding cost; the cost of bearing default risk falls; and the deal generates fee income. Consider a nine-year credit card ABS from Commercial Finance Partners AG (CFP), a bank based in Europe, with a CHF900,000,000 issue size, a three-year revolving period, and a six-year amortization period. The pool holds CHF925 million of Swiss credit card receivables, with an average balance of CHF2,300 and a weighted average interest rate of 12%.

The cash reaching the pool has three parts: finance charges, fees, and principal. Finance charges are the interest the lender applies to the unpaid balance, and the rate may be fixed or floating; a floating rate is usually capped at an upper limit. Fees include late-payment charges and any annual membership fee. Because the loans do not amortize, through the revolving period, which runs three years here, holders collect only finance charges and fees, never principal.

Some credit card deals include early amortization, or rapid amortization, provisions that protect credit quality, especially during the revolving period. If repayments no longer replenish the pool, or if defaults reshape it enough to undermine the economics, a rapid amortization clause fires and accelerates principal back to noteholders, who can then redeploy the cash elsewhere. Such clauses are especially welcome when the macroeconomic outlook is turning uncertain.

Solar ABS

As more homeowners install solar systems, specialty finance firms have created solar loans, which let a consumer borrow the cost of buying and installing a system, and solar leases, which rent the equipment from a solar company. The economics are simple: the utility savings from switching to solar are expected to outrun the cost of the system, and institutional investors like the mix of a sustainability contribution with an attractive risk-adjusted yield. Take Al-Shims Enterprises, which securitizes solar loans through a financing subsidiary. The solar ABS issues EUR300 million of notes secured by 10,000 residential home-improvement loans that carry EUR320 million of face value; the loans average EUR32,500 each, the weighted average rate is 7.5%, and the weighted average maturity is 17 years, with every loan amortizing.

Because the proceeds fund green projects, solar loans can qualify as green bonds and appeal to investors pursuing environmental, social, and governance (ESG) or climate mandates. The legal form depends on the jurisdiction; when the solar loan is structured as a residential home-improvement loan, the ABS effectively securitizes a junior mortgage on the property. Investors favor this debt because solar borrowers are usually prime homeowners with good payment records, and they are further protected by overcollateralization, subordination, and excess spread. Many solar ABS also include a pre-funding period, letting the trust acquire additional qualifying loans for a set time after closing.

A collateralized debt obligation (CDO) sells securities whose backing is a diversified pool made of one or more kinds of debt. The label is generic, and the name of the deal follows its collateral. A pool of corporate and emerging-market bonds makes a collateralized bond obligation (CBO); a pool of leveraged bank loans makes a collateralized loan obligation (CLO); a pool of other CDOs makes a structured finance CDO; and a pool built from credit default swaps on other structured securities makes a synthetic CDO. The dominant form today is the CLO, whose collateral is leveraged bank loans.

Like the ABS already covered, a CDO redistributes the pool’s cash flows across tranches. What sets most CDOs apart is that the pool is not static: a collateral manager trades debt in and out to keep cash sufficient for what is owed to the CDO’s bondholders. Proceeds to pay the classes come from three places: interest on the collateral, collateral that matures, and collateral that is sold. The core economics require that the return on the pool beat the funding cost, meaning the combined cost of the classes issued. Senior and mezzanine holders earn fixed returns, while the equity tranche and the manager earn equity-like returns. In effect a CDO is a leveraged trade: equity holders use the borrowed funds raised by the debt classes to earn a return above the funding cost.

The market has shifted since the 2003 to 2007 era. Back then the collateral reached across assorted real estate debt as well as commercial mortgage-backed securities (CMBS); today it is mostly leveraged bank loans, that is, CLOs. Regulatory and legal changes made building and buying CDOs less attractive, but the securitization framework is much the same, and it is seen most clearly in the CLO.

The generic CLO structure

A CLO raises the money to buy its collateral by issuing debt, split into senior, mezzanine, and subordinated (junior or equity) tranches. Investors in the senior or mezzanine classes can pick up a higher yield than similar corporate bonds pay, or reach exposures they could not otherwise buy. Equity investors take on equity-like risk with the chance of equity-like returns, and this residual tranche is decisive: a CLO is only viable if its structure pays that tranche a competitive return. CLOs come in three main flavors. Cash flow CLOs, the most common, redistribute interest and principal across the tranches. Market value CLOs let each tranche’s value track how the portfolio is priced in the market. Synthetic CLOs assemble the pool through credit derivatives.

A CLO pool is typically diversified across roughly 100 to 225 issuers of senior secured loans, its value is set above the value of the CLO debt, and a collateral manager runs it actively. The manager must keep passing performance tests and staying within collateral limits. If a test fails, a provision requires principal to be paid down to the senior class until the tests pass again, which deleverages the CLO by shrinking its cheapest funding source. The portfolio is not finalized at closing: most loans are bought beforehand, more are added during a ramp-up period, and afterward the manager may swap loans as long as replacements meet the selection criteria. Any recourse stops at the collateral pool, reaching the original issuers only barely.

Coverage tests give the debt tranches varying protection. A leading example is the overcollateralization test, which keeps the principal value of the loan pool above the total principal of the notes for as long as the CLO debt is outstanding. If the pool falls below the trigger, cash is steered away from equity and junior debt toward the senior tranche.

CLOs run several other tests in concert to protect debt investors: measures of industry diversification, single-obligor limits on how much exposure any one borrower may carry, and caps on the amount of CCC-rated debt in the pool to contain negative credit drift. Throughout, the collateral manager is central. By choosing, managing, and trading the loans, the manager acts like an active bond portfolio manager, shaping the asset mix and the risk of the pool.

That active role is also the source of an extra risk. Alongside the usual ABS risks, the default risk on the collateral and the possible mismatch between fixed-rate collateral and floating-rate notes, a CLO investor also bears the risk that the manager fails to earn enough to pay the senior and mezzanine classes. Current CLOs are generally simpler than the CDOs at the center of the financial crisis: structured finance CDOs assembled out of other CDOs have faded from use, and even synthetic CLOs turn up less often. Since the crisis, the underlying asset quality of CLOs has drawn closer scrutiny.