9 – The Origins of Asset Backed Securities (ABS) – Part II

Photo by Austin Distel on Unsplash

In the last article we have seen how the shadow banks finance their acquisition of assets via market financing (or securitization) as compared to deposit financing practiced by commercial banks.

Before we start, remember: All financial institutions raise funds to acquire assets by issuing their liabilities.

Commercial banks raise fund finance the acquisition of assets such as loans by issuing deposit liabilities to the depositors. Shadow banks raise fund finance the acquisition of assets such as pool of loans by issuing ABS (i.e. liabilities) to investors in the financial markets such as pension fund, mutual fund, hedge fund etc.

Securitization of loans such as issuing of ABS brought a few important changes to the financial system:

  1. Changes in the operating model of loan originator
    • Since there’s always a demand from the investor looking for higher yield, so there is high demand for ABS, hence shadow banks such as SPVs expand their pool of loans by demanding more loans from the loan originator.
    • Before securitization is practised, the loan originator such as commercial banks extend a loan and hold the loan as assets in their balance sheets. This is known as “originate-to-hold” model.
    • After securitization is practised, since there’s a huge demand of loans from the SPVs, the loan originator sell the loans to the SPVs in exchange for more liquid assets such as currency and thus taking the loans of their balance sheet. 
    • This is known as “originate-to-distribute” model as the loan originator distributes the loan they extended to the SPVs instead of holding them in their balance sheets.
    • As the loan originator start to take more loans off their balance sheet by selling them to SPVs, their non-interest income such as origination fees and servicing fees paid by the SPVs increases.
    • Securitization fueled the transition of loan originator from “originate-to-hold” model to “originate-to-distribute” mode.
  2. Risk sharing and lower cost of financing 
    • Shadow banks acquire the funds to purchase the loans pool from loan originator from the market or investors who are money manager such as pension fund, mutual fund etc.
    • So, securitization extends the pool of available fund resources to be used for lending to household and firms.
    • This decrease the cost of financing for household and firms as the pool of fund available for borrowing is abundant.
    • Also, previously, the credit risk of loans is concentrated at the banks that originate the loans. Hence, banks often charged higher interest to the lender, resulting in high cost of financing for household and firms.
    • Now, since ABS (which is secured by pool of loans) is bought by different investors, the credit risk is scattered in the economy and now shared by a larger group of people instead of solely bear by the bank. 
    • This also contributes to lower cost of financing for household and firms.

Let’s look into other financial instrument such as: MBS, CDO, ABCP and CDS

  1. Mortgage-backed securities (MBS)
    • MBS is a variant of ABS. Remember: ABS is long-term liabilities issued by SPVs that’s secured by pool of loans consists of auto loans, credit card loans, student loans, mortgages etc. to raise fund to finance the acquisition of those loans.
    • When the bonds or securities issued by SPVs is secured by pool of loans consists of only mortgage loans, the bonds/securities are called MBS.
      • In other words, MBS is issued by SPVs to raise fund to finance the acquisition of mortgage loans.
    • Since mortgage loans are usually long-term loans as the lender take years to repay, the maturity of MBS is also very long.
Diagram

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Figure 1: MBS is the liabilities secured by pools of mortgage loans issued by the SPV, the investors purchase MBS from SPV, seeking higher yield.
  • Collateralized Debt Obligation (CDO)
    • CDO is special type of ABS as it is the long-term liabilities issued by SPVs to raise fund to finance the acquisition of corporate bonds, structured credit product such as ABS or MBS issued by other agencies.
    • So, CDO is secured by corporate bonds, or a pool of ABS or MBS issued by other agencies.
    • When a collateral is ABS (general ABS), it’s also known as ABS CDO.
    • When the CDO is secured by only MBS as collateral, the CDO is also known as Collateralized Mortgage obligation (CMO).
Table

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Figure 2: CDO is the liabilities secured by MBS issued by the SPV, the investors purchase CDO from SPV, seeking higher yield.
  • Asset backed commercial Paper (ABCP)
    • ABCP is short-term liabilities issued by the SPVs to raise funds to finance the acquisition of long-term assets such as ABS, MBS and CDO.
      • ABCP is therefore also secured by ABS, MBS and CDO, depends on what assets the SPVs choose to acquire using the funds raised from ABCP.
    • ABCP has very short time to maturity from 1-4 days, 21-40 days to more than 80 days. This means that the SPVs has to repay the ABCP liabilities (principal + interest) in a short time. 
    • However, the assets acquired using the funds raised from ABCP are long-term assets which has very long time-to-maturity, so the SPVs often have to roll over their short-term ABCP liabilities by issuing a new batch of ABCP.
    • The reason SPVs issued short-term liabilities like ABCP to raise fund is because short-term liabilities are cheaper as the interest required by the ABCP buyer is lower.
Table

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Figure 3: ABCP is short-term  liabilities secured by ABS (such as MBS)  issued by shadow banks, the investors seeking for short-term yield purchase ABCP from them.
  • Credit Default Swap (CDS)
    • CDS is the contingent liabilities issued by shadow banks that promise to compensate the holder of MBS, CDOs and other assets in case these assets go bad.
    • Unlike ABS which is offered publicly to investor, CDS is private arrangement between the holder of MBS, CDOs (the investor) and the shadow banks such as insurance company in which the insurance company promise payment if the assets held by the investor goes bad.
      • The private arrangement is done in “Over the Counter” (OTC) market.
    • The investor paid premium to the insurance company in exchange for CDS.
    • CDS is the contingent liabilities of the issuer because if the assets the investor held goes bad, the issuer of CDS is liable to the investor because the issuer is obligated to help investor cover their losses as promised.
    • One huge issuer of CDS during 2007-2008 is AIG.
Diagram

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Figure 4: CDS is contingent liabilities issued by shadow banks (such as insurance company), the investors who want to insure their assets purchase CDS by paying a premium.

Conclusion for this article:

  1. MBS, CDO, ABCP – All of them are liabilities issued by shadow banks to raise fund for acquisition of assets. 
    • MBS is secured by pools of mortgage loans. CDO is secured by pools of ABS such as MBS. 
    • Since mortgage loans is household liabilities, MBS is SPV’s liabilities, CDO is also SPV’s liabilities, so we can say that: CDO is liabilities issued by SPV secured by another SPV’s liabilities which is secured by household liabilities.
    • This is also known as financial layering: “A debt on a debt on another debt.”
  2. MBS, ABS and CDO is long-term liabilities that usually mature in > 13 months; ABCP is short-term liabilities that usually mature in < 13 months. 
  3. CDS is contingent liabilities issued by the shadow banks such as insurance company who promised to cover the losses of the holder of assets (investor) such as MBS, CDO etc. in case their assets go bad.
    • If the assets of the investor doesn’t go bad in the timeframe protected by the insurance company, the premium earn from issuing CDS is therefore pure profits for the insurance company.

*** This article is just the tip of the iceberg of securitization, see more about securitization in the Part III of The Origin of ABS.

References:

  1. Shadow banking: A review of the literature
  2. The Origins of the Financial Crisis

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