Analyzing Credit of Asset Backed Securities

An asset-backed security is a security whose price and income is derived from a specific pool of underlying assets (or collateral).

These securities are debt obligations that represent claims to the payments or cash flows from pools of different asset classes (loans). Some examples of these assets are credit card loans, auto loans, bank loans, etc. If the underlying collateral is mortgages, then the securities are called mortgage-backed securities. These loans from banks, mortgage companies, and other originators are assembled into pools. The entity then issues securities based on these pools that represent claims on the principal and interest payments/cash flows made by borrowers on the loans in the pool.

Common considerations for analyzing asset-backed securities include:

• Credit quality of the underlying collateral. This is the most important factor, as the quality of the collateral will define the success of an ABS deal, the timely payments of cash flows, etc. We also need to look for the concentration risk, that is, the scenario where an asset pool holds loans from only a small group of borrowers, or is concentrated in a particular demographic.

• Servicer quality: Given the servicer’s key role in administering and managing the loan pool, it is imperative to understand the servicer’s ability to effectively perform its functions.

• Payment structure and cash flow capability of the asset pool. The analyst must carefully analyze the payment structure and the cash flows of the asset pool. The availability of liquidity / credit enhancement / insurance are also important. In case of a fully supported ABS transaction, the repayment is supported by a financial guarantee, such as a surety, letter of credit, third-party guarantee, or liquidity facility. In case of a partially-supported ABS deal, the repayments are supported by cash flows from the pool, and liquidity and credit enhancement.

• Legal structure of the asset backed security.