Rescuing Asset-Backed Securities Markets
Agarwal, Sumit, Cun, Crystal, De Nardi, Mariacristina, Chicago Fed Letter
On November 25, 2008, the Federal Reserve unveiled a loan facility to revive the market for asset-backed securities, which had essentially stopped functioning due to the global financial crisis. What are these securities and why is it important for these markets to continue to operate?
Asset-backed securities (ABS) are bonds backed by the cash flow of a variety of pooled receivables or loans. Firms issue ABS to diversify sources of capital, bor- row more cheaply, reduce the size of their balance sheets, and free up capital. Securities backed by auto loans, credit card receivables, student loans, and home eq- uities represent the largest ABS market segments. The ABS market grew dramati- cally from the begin- ning of 1998 through 2006. when supply peaked at $888 billion in the U.S.1 In August 2007. the ABS market began shrinking in stages, with bond issues backed by residential mortgages drying up first, followed by the collapse of both the consumer ABS (auto, credit card, and student loan segments) and the com- mercial mortgage-backed securities markets. After the failure of Lehman Brothers in October 2008, investor con- fidence was further undermined and yields on ABS skyrocketed. This result- ed in large increases in interest rate spreads - i.e., the difference between ABS yields and risk-free yields, such as the Treasury rate and Libor (London interbank offered rate) . In the new highyield environment, there was no economic incentive for lenders to issue new ABS; and the intermediation of household and business credit between investors and borrowers ground to a halt.
To help ease the strain on the ABS market, the Fed introduced the Term Asset-Backed Securities Loan Facility (TALF) on November 25, 2008. This facilitated the renewed issuance of ABS at interest rate spreads closer to those available prior to the Lehman collapse.
Since the introduction of the TALF, ABS interest rate spreads have narrowed from historical highs in the fourth quarter of 2008. Spreads on three-year AAArated ABS (the highest quality rating) backed by credit card receivables and auto loans have fallen to approximately one-sixth of their peaks (see figure 1). At the consumer level, credit availability at auto finance companies has improved as interest rates on new auto loans also declined to 2.74% in March 2009 from a high of 7.09% in December 2008.2 This indicates greater liquidity in the ABS markets and improved capital funding options for firms.
Issuance for the consumer ABS market has also increased across the credit card, auto loan, student loan, and home equity loan sectors. In the second and third quarters of 2009, new issuance of consumer ABS averaged $45 billion per quarter, rebounding to just under pre-crisis levels.3
In this Chicago Fed Letter, we examine two specific types of ABS - credit card and auto floor plan - to provide some insight into their significance to the broader economy and the motivation for policy intervention to keep ABS markets afloat. Credit card ABS are a major part of the consumer ABS market, while auto floor plan ABS are a niche product designed to support auto dealers and manufacturers.
How do credit card and auto floor plan ABS work?
Credit card ABS are backed by credit card receivables, made up of annual percentage rate (APR) charges, annual fees, late payment fees, over-limit fees, recoveries on charged-off accounts, and interchange (processing) fees from merchants. Though most of these components are relatively stable, interest income derived from APR charges makes up the majority of the yield, and this income is highly variable.4
Auto floor plan ABS help securitize the financing for auto dealer inventory. The financing for auto floor plan ABS involves a revolving credit agreement between the dealer, lender, and manufacturer, and it is secured through a first lien (primary claim) on the dealer's inventory. As the dealer sells the inventory, a portion of the sales proceeds goes toward repayment of the loan. …