Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrower’s inability to meet interest payment

obligations on time. For ABS, default may occur when maintenance obligations on the underlying

collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular

security’s default risk is its credit rating. Different tranches within the ABS are rated differently,

with senior classes of most issues receiving the highest rating, and subordinated classes receiving

correspondingly lower credit ratings.[7]

Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of

early amortization risk. The risk stems from specific early amortization events or payout events that

cause the security to be paid off prematurely. Typically, payout events include insufficient payments

from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread,

a rise in the default rate on the underlying loans above a specified level, a decrease in credit

enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.[7]

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move

in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices

less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest

rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on

underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the

most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are

generally less sensitive to interest rates.[7]

Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying

assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices

of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager

has a claim on the deal's excess spread.[9]

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes

insolvent. This risk is mitigated by having a backup servicer involved in the transaction.[7]

History

"Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades

before that, banks were essentially portfolio lenders; they held loans until they matured or were paid

off. These loans were funded principally by deposits, and sometimes by debt, which was a direct

obligation of the bank (rather than a claim on specific assets). But after World War II, depository

institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as

other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of

mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle

that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the

underlying loans. Although it took several years to develop efficient mortgage securitization

structures, loan originators quickly realized the process was readily transferable to other types of

loans as well."[4]

In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a

mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold

securities backed by a portfolio of mortgage loans. [10]

To facilitate the securitization of non-mortgage assets, businesses substituted private credit

enhancements. First, they over-collateralized pools of assets; shortly thereafter, they improved third-

party and structural enhancements. In 1985, securitization techniques that had been developed in the

mortgage market were applied for the first time to a class of non-mortgage assets — automobile loans. A

pool of assets second only to mortgages in volume, auto loans were a good match for structured finance;

their maturities, considerably shorter than those of mortgages, made the timing of cash flows more

predictable, and their long statistical histories of performance gave investors confidence.[4]

This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and

securitized in 1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).[11]

The first significant bank credit card sale came to market in 1986 with a private placement of $50

million of outstanding bank card loans. This transaction demonstrated to investors that, if the yields

were high enough, loan pools could support asset sales with higher expected losses and administrative

costs than was true within the mortgage market. Sales of this type — with no contractual obligation by

the seller to provide recourse — allowed banks to receive sales treatment for accounting and regulatory

purposes (easing balance sheet and capital constraints), while at the same time allowing them to retain

origination and servicing fees. After the success of this initial transaction, investors grew to accept

credit card receivables as collateral, and banks developed structures to normalize the cash flows.[4]

Starting in the 1990's with some earlier private transactions, securitization technology was applied to

a number of sectors of the reinsurance and insurance markets including life and catastrophe. This

activity grew to nearly $15bn of issuance in 2006 following the disruptions in the underlying markets

caused by Hurricane Katrina and Regulation XXX. Key areas of activity in the broad area of Alternative

Risk Transfer include Catastrophe bonds, Life Insurance Securitization and Reinsurance Sidecars.

As estimated by the Bond Market Association, in the United States, total amount outstanding at the end

of 2004 at $1.8 trillion. This amount is about 8 percent of total outstanding bond market debt ($23.6

trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate

debt ($4.7 trillion) in the United States. In nominal terms, over the last ten years, (1995-2004,) ABS

amount outstanding has grown about 19 percent annually, with mortgage-related debt and corporate debt

each growing at about 9 percent. Gross public issuance of asset-backed securities remains strong,

setting new records in many years. In 2004, issuance was at an all-time record of about $0.9 trillion.

[12]

At the end of 2004, the larger sectors of this market are credit card-backed securities (21 percent),

home-equity backed securities (25 percent), automobile-backed securities (13 percent), and

collateralized debt obligations (15 percent). Among the other market segments are student loan-backed

securities (6 percent), equipment leases (4 percent), manufactured housing (2 percent), small business

loans (such as loans to convenience stores and gas stations), and aircraft leases. [12]