Asset-Backed Securities (ABS) vs. Mortgage-Backed Securities (MBS): Overview

Asset-Backed Securities (ABS) vs. Mortgage-Backed Securities (MBS)

Asset-Backed Securities (ABS) and Mortgage-Backed Securities (MBS) are two of the most important types of asset classes in the fixed income industry. MBS is created from a pool of mortgages sold to interested investors, while ABS is created from a pool of non-mortgage assets. These securities typically back credit card receivables, home equity loans, student loans, and auto loans. The ABS market developed in the 1980s and is becoming increasingly important to the US debt market. Despite their apparent similarities, there are key differences between the two types of assets.

The structure of this type of security is based on three parties: the seller, the issuer, and the investor. Sellers are the companies that originate loans for sale to issuers and act as servants, collecting principal and interest payments from borrowers. ABS and MBS providers benefit because they can be removed from the balance sheet, allowing providers to obtain additional financing.

Issuers buy loans from sellers and pool them to release ABS or MBS to investors, which can be a third-party company or a special purpose vehicle (SPV).ABS and MBS investors are institutional investors who typically use ABS and MBS to earn higher returns than government bonds and provide diversification.

key takeaways

  • Asset-backed securities (ABS) are created by pooling non-mortgage assets, such as student loans. Mortgage-backed securities (MBS) are created by pooling mortgages.
  • ABS and MBS providers benefit because they can be removed from the balance sheet, allowing providers to obtain additional financing.
  • Both ABS and MBS have prepayment risks, although these are particularly pronounced in the case of MBS.
  • ABS also carry credit risk, when they use senior subordinated structures (known as credit tranches) to deal with risk.
  • ABS and MBS can be evaluated using a variety of methods, including zero volatility and tight option spreads.

Asset-Backed Securities (ABS)

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

ABS mortgage guarantee

Home equity loans are very similar to mortgages, making home equity ABS similar to MBS. The main difference between home equity loans and mortgages is that home equity loan borrowers usually do not have good credit ratings, so they have not been able to obtain a mortgage. Therefore, investors should review borrowers’ credit ratings when looking at ABS backed by home equity loans.

ABS Auto Loan

Auto loans are types of amortized assets, so ABS loan cash flows include monthly interest, principal, and prepayment. The prepayment risk of an ABS auto loan is much lower compared to MBS or Home Equity Loan. A prepayment only occurs when the borrower has additional funds to pay off the loan.

Refinancing rarely happens when the interest rate drops because cars depreciate faster than the loan balance, making the value of the car warranty less than the outstanding balance. Balances on these loans are often small, and borrowers will not be able to save significant amounts by refinancing at a lower interest rate, with little incentive to refinance.

ABS credit card receivable

Credit card receivables are a type of unamortized ABS asset. They do not have scheduled payment amounts and new loans and changes to the composition of the group can be added. Cash flows from credit card receivables include interest, principal payments, and annual fees.

There is usually a lock-in period for credit card receivables when the principal is not paid. If the principal is paid within the lock-in period, new loans will be added to the ABS and the principal payment will leave no change in the pool of credit card receivables. After the lock-up period, the principal payment is transferred to the ABS investors.

Mortgage-Backed Securities (MBS)

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

Ginnie Mae’s MBS is backed by the full faith and credit of the US Government, ensuring that investors receive full and timely payments of principal and interest. In contrast, Fannie Mae and Freddie Mac MBS do not support the full faith and credibility of the US government, but both have special authority to borrow from the US Treasury if necessary.

Mortgage-backed securities can be purchased at most full-service brokerage firms and some discount brokers. The minimum investment is usually $10,000; however, there are some variations of MBS, such as Collateralized Mortgage Obligations (CMOS), which can be purchased for less than $5,000.Investors who do not want to invest directly in mortgage-backed securities, but who want exposure to the mortgage market, may want to consider exchange-traded funds (ETFs) that invest in mortgage-backed securities.

Notable ETFs that invest in MBS include the iShares MBS ETF (MBB) and the Vanguard Mortgage Supported Securities Index ETF (VMBS).ETFs are traded like stocks on regulated exchanges and can be sold short and bought on margin. Like stocks, the Foundation’s prices fluctuate during each trading session in response to market events and investor activities.

Special Considerations

Both ABS and MBS have prepayment risks, although these are particularly pronounced in the case of MBS. Prepayment risk means that borrowers are paying more than their required monthly payments, thereby lowering the interest on the loan. Prepayment risk can be determined by the difference between current and issued mortgage rates, home turnover, and mortgage rates.

For example, if a mortgage rate starts at 9%, drops to 4%, goes up to 10%, and drops to 5%, homeowners are more likely to refinance their mortgages the first time rates drop. Therefore, to deal with prepayment risk, ABS and MBS have cross-cutting structures to help spread prepayment risk. Investors can choose a tranche based on their preferences and risk tolerance.

An additional type of risk associated with ABS is credit risk. ABS has a senior subordinated structure to deal with credit risk known as a credit tranche. The subordinated or junior tranches will carry all losses down to their value before the losses on the senior tranches begin. Sub-tranches tend to have higher returns than senior tranches due to the higher risk incurred.

Asset-backed securities and mortgage-backed securities can be quite complex in terms of their structure, features, and valuations. Investors have access to these securities through indices such as the US ABS Index. For those who wish to invest directly in ABS or MBS, it is essential to do extensive research and weigh your risk tolerance before making any investment.

ABS vs. MBS Example

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

For example, we can use the Z margin to measure credit card ABS and car loan ABS. Credit card ABS has no options, so Z-spread is an appropriate measure. While auto loan ABS do have prepayment options, they are generally not exercised, so Z margin can be used for measurement.

If the security has built-in options, the option-adjusted margin (OAS) should be used. The OEA is the adjusted margin for embedded options. To derive the OEA, the binocular model can be used if the cash flows depend on current interest rates, but not on the path that caused the current interest rate.

Another way to derive the OEA is the Monte Carlo model, which should be used when the cash flow of securities depends on the path of the interest rate. MBS and Home Equity are security types that depend on interest rate pathways where the OAS Monte Carlo model would be used for valuations. However, this model can be quite complex and should be checked for accuracy during use.

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