Asset-backed securities

In this market a mortgage lender, for example, collects together a few thousand of its mortgage ‘claims' (the right of the lender to receive regular interest and capital from the borrowers); it then sells those claims in a collective package as bonds to other institutions, or participants in the market generally.

The borrower is usually unaware that the mortgage is no longer owned by the original lender and everything appears as it did before, with the mortgage company acting as a collecting agent for the buyer of the mortgages. The mortgage company is usually said to be a seller of asset-backed securities (ABS) to other institutions (the ‘assets' are the claim on the mortgage interest and capital) and so this form of finance is often called asset securitisation.

Rather than selling bonds in the mortgage company itself, a new company is established, called a special purpose vehicle (SPV) or special purpose entity (SPE). This new entity is then given the right to collect the cash flows from the mortgages. It has to pay the mortgage company for this. To make this payment it sells bonds secured against the assets of the SPV (e.g. mortgage claims). By creating an SPV there is a separation of the creditworthiness of the assets involved from the general creditworthiness of the parent company.

Asset-backed securitisation involves the pooling and repackaging of rela­tively small, homogeneous and illiquid financial assets into liquid securities.

The sale of the financial claims can be either ‘non-recourse', in which case the buyer of the securitised bonds (the lender to the SPV) bears the risk of non-payment by the mortgage holders, or ‘with recourse' to the mortgage lender should the mortgage payment fall short (with recourse the bonds might be said to have ‘credit enhancement').

Example 15.1

Car loan securitisation

GM Financial, the subsidiary of General Motors responsible for administering car loans, which regularly securitises its loans, explains securitisation on its website. Notice the recourse to GM if some customers do not pay - it suffers any ‘credit losses':

The securitization named 2007-D-F has an average customer interest rate of 16.9 percent, but we are only required to pay the investors approxi­mately 5.5 percent. Therefore, GM Financial will earn a 11.4 percent net interest margin (16.9 percent minus 5.5 percent) on these loans before covering credit losses, operating expenses and any fees associated with the securitization. Utilizing a securitization locks in the net interest margin for the company for the entire life of the securitization, removing exposure to changes in interest rates for these specific loans.

As net interest margin is generated, cash is available to the company to cover operating costs, credit losses and taxes. Anything left over is GM Financial's profit. This can be reinvested in new loans. Then, we start the cycle again - originating new loans, funding our dealers and transferring loans to warehouse lines or securitization trusts.

Source: www.gmfinancial.com