What is Asset Backed Risk?

Asset Backed Risk:

An asset backed risk (ABS) is a fixed income instrument structured as a securitized interest in a pool of assets. In general term,  assets backed securities are understood  to be  securitisation of auto loans, credit card receivables, home equity loans and student loans.

ABS carries the CREDIT RISK. Diversification of underlying assets, credit enhancements or trenching can mitigate this. ABS can be subject to prepayment risk. Consumer are more likely to refinance a home than an auto in response to a drop in interest rate

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ABS are appealing to issuers because the structure allows them to get assets off their balance sheets, freeing up capital for further receivables. However, Sarfaesi Act, 2002 Act (The Securitisation and Reconstruction of Financial Assets and Enforcement of  Security Interest Act, Sarfaesi Act, 2002) is requires issuers of all securitisation to retain some of the credit risk of those instruments.  Assets backed securities do make it possible for issuers whose unsecured debt is below investment grade to sell investment debt.

To create an asset backed security, a corporation creates a special purpose vehicle to which it sells the assets. While it is common to speak of the corporation as the issuer of the asset backed security, it is legally the trust of special purpose vehicle that is the issue. It is the trust or the special purpose vehicle that sells securities to investors.

To protect investor from possible bankruptcy of the corporation, there are three legal safeguards:
1) Investor receive a perfected interest in the assets’ cash flows.

2) Transfer of assets from the corporation is a non-recourse, true sale.

3) A non-consolidation legal opinion is obtained certifying that asets of the trust or special pupose vehicle cannot be consolidated with the corporation’s assets in the event of bankruptcy.

These same safeguards allow the corporation to remove the assets from its balance sheet. The corporation generally continues to service the assets collecting interest and principal payment, pursuing cash flow for providing these ongoing services. For investors, assets backed securities are an altenative to highly rated corporate debt. They generally offer similar or superior liquidity. Because the underlying assets are diversified, they are less subject ot credit surprises.  ABS can be structured into different classes or trenches, much like Collateralized Mortgage Obligation (CMOs). They may be structured with different average maturities. Choice of structure depends upon investor demand as well as the nature of the underlying assets.