ABS Analysis: A Rigorous Approach

Article excerpt

This article identifies three areas in asset-backed securities structuring that are crying out for standardization. An introduction to ABS leads to discussion of the three areas: 1) recognizing losses and recoveries; 2) ensuring that the subordinate investor's principal cash flows are, in fact, subordinated; and 3) eliminating the ratings cliffs. The author concludes that clearer rules of play would make analysis more accessible to banks considering asset-backed securities.

Many bankers find the structuring--and analysis--of asset-backed securities (ABS) off-puttingly complex. The complexity is not due entirely to the brilliance of the financial minds that fashion ABS. In large part it is due to a lack of rigor in a market that has grown astonishingly quickly over the past quarter of a century.

The word "rigor" may also be offputting. But, paradoxically perhaps, rigor really means simplifying the analysis. Another way of saying "rigor" is standardization: the consistent and uniform application of process in structuring and valuing ABS. This article identifies three areas in ABS structuring that are crying out for rigor and standardization. To put these remarks in context, let's review the main features of an ABS.

ABS are debt securities backed by pooled nonmortgage collateral. Special-purpose entities (SPEs) in effect purchase collateral from financial institutions when they issue the ABS, and they service the debt from collections. (1) All classes of investors in ABS take an undivided interest in the collateral (recoveries on defaulted receivables are almost always part of the trust) but each class differs from every other class in respect to its priority of claim on the cash flows. Senior investors receive interest payments before investors further down the capital structure. Their principal is repaid first as well.

The value in ABS, therefore, derives from the cash generated by the collateral. Because cash from the collateral is the SPE's sole repayment resource--one that will eventually dry up--the primary risk is if assets expire before they mature (default), thus reducing the interest and principal that can be repaid to the investor. This risk is partially mitigated by the amount of spread (the excess of the asset earning rate over the asset funding rate) in the transaction. The risk is further mitigated by any features included in the transaction structure--such as subordination, overcollateralization, reserving, or optionality (deal triggers)--designed to increase repayment certainty for the senior noteholders.

Who the ultimate beneficiary in ABS, and what's the point? ABS allows the originator to "beat the system" through a financing structure that obtains more favorable treatment according to a given set of rules, which reduces the overall funding cost.

By far, the simplest system to beat is that of corporate ratings, in which the originator has some assets that are a better credit risk than its own corporate credit. The originator frees its collateral from its own default risk by securitizing the assets and selling off the debt in a top-heavy capital structure (maximizing the issue size at the AAA/Aaa level) and pocketing the difference in change.

At its best, ABS is a very good game. More information on asset quality gets disclosed in the process than could ever be coaxed from an audited balance sheet, and more controls are placed on the sources and uses of the SPE's cash than would be possible in a traditional corporate financing.

At its worst, it is a very bad game involving fraud. However, preventing fraud is relatively straightforward if certain measures are consistently applied at the outset. Identification, verification, and valuation of the assets going into the SPE by an independent party are critically important. It's just as important to get an unequivocal opinion from a competent legal authority that 1) the assets have been sold to the SPE at something like fair value; 2) the sale puts the assets essentially outside the control of the seller; and 3) the assets would not be considered part of the seller's estate should the seller go bankrupt. …