Meaning of ABS

Asset-backed securities, or ABS for short via abbreviationfinder, are translated as “asset backed securities”. ABS belong to the group of structured financial products. They came up in the USA in the 1980s and were used for refinancing. How does an ABS work and what are the associated risks?

• Asset-backed securities are used to refinance and obtain liquidity for banks.
• Receivables, i.e. loans, are combined in packages so that a bond is backed and this bond is sold on the market.
• Banks are thus reducing the relationship between credit risks and liable equity.
• Asset-backed securities from the former US investment firm Lehman Brothers were the main trigger for the global financial crisis in 2008.

What are asset-backed securities?

On the one hand, the term asset-backed security is used as a product group and, on the other hand, as a generic term for several product groups.

ABS as a product group

As an independent product group, asset-backed securities are divided into:

• Secured commercial paper (ABCP)
• Mortgage-backed security (MBS)

The latter are further subdivided into securities with mortgages from residential real estate (Residential MBS, RMBS) and from commercial real estate (Commercial MBS, CMBS).

Mortgage-backed ABS provide a good basis for the explanation. A bank has 10,000 mortgage loans . She would like to refinance away from the central bank. Because of this, she aggregates 2,500 of the mortgage loans and makes a bond out of them. The bond is secured by the land charge of the mortgage loan. She is now selling this bond to an investor. The bank is liquid again, the investor receives his interest from the mortgage loans of the loans bundled in the bond.

ABS as a generic term

The generic term of asset-backed securities also includes the product group of CDOs, the collateralized debt obligations. These in turn are divided into:

• CLO: Collateralized Loan Obligation
• CBO: Collateralized Bond Obligation (Bonds)
• CMO: Collateralized Mortgage Obligation

While a classic ABS does not classify the liabilities bundled in it, a CDO does this. The type of classification shows that a CDO is sometimes not for the faint of heart. It is divided into three tranches with falling credit ratings of the underlying debt: senior, mezzanine and equity. While “Senior” is still considered acceptable, the credit default risk for “Equity” is above average. The interest for the last tranche of the package is correspondingly high.

Advantages of Asset Backed Securities

The benefits are pretty clear. A bank separates from loans , creating liquidity on the one hand and improving the relationship between equity and loans on the other. The liability of the equity capital is relieved. Often, separate companies are set up to take over ABSs, which take over the loan packages. German commercial and tax law offers another special feature. If the loans are not sold, but only the credit risk is transferred as part of a credit default swap, the receiving company does not have to pay any trade tax on the interest income.

Another advantage is that the refinancing costs are significantly lower than with other refinancing instruments, such as the issue of a real bond.

Ideally, the securitized receivables are included in the bond package with a significant risk discount. Possible credit losses are therefore not noticeable within a certain framework. Another variant of overcollateralization is that the nominal value of the bond is set lower than the total value of the claims securitized in the bond. In addition to overcollateralization, setting up a reserve account can also increase the security of the bond. The surpluses from the bundled loans that are not required for ongoing business flow into the reserve account.

Disadvantages of Asset Backed Securities

Since the financial crisis it has not become uncommon for banks to explicitly assure their private customers that no loans will be sold to third parties. The pooling of loans and subsequent outsourcing has a bland aftertaste that stems from the years 2007 and 2008.

The 2008 financial crisis relentlessly exposed the weak point of asset-backed securities, particularly in the case of mortgages. The US investment house Lehman Brothers had a lively trade in asset-backed securities, which consisted of mortgage letters from private property owners.

However, the US economic crisis at the time left homeowners unable to pay their mortgages. The US real estate market was literally inundated with properties belonging to insolvent owners, and real estate prices collapsed completely. With the collapse of the real estate market, the mortgage collateral and with it the loans and ABSs were worthless.

ABS bonds for corporate finance

Companies can also use ABS bonds for refinancing. The principle: Selected receivables are sold to a subsidiary at the current value at the time of sale. The subsidiary often only serves the purpose of the ABS bond. In turn, the subsidiary finances the purchase price through the ABS bond, which is secured by the receivables. By selecting the receivable (only first-class receivables are sold), the subsidiary gets a better rating and thus lower financing costs.