DERIVATIVES R US/V1N4/Asset-Backed Securities
VOLUME 1, NUMBER 4
This week s topic is:
***** ASSET-BACKED SECURITIES *****
Starting in the middle 1980s, a new type of financial instrument called the Asset-Backed Security (ABS) was created. An ABS is an instrument constructed by packaging a group of securities and then issuing a security whose purchaser has a claim against the cash flows generated by the original package. This process became known as securitization. Most ABSs contain additional features that can make them complex and give them option-like characteristics. The prepayment feature of your mortgage is the best example.
One of the first types of ABSs was the mortgage pass-through security. A firm would put together a portfolio of mortgages and then sell claims against that portfolio. Oftentimes the firm would secure credit insurance on the package by paying a small fee. An individual investor could, therefore, purchase a piece of a credit risk-free mortgage portfolio. He would then receive a monthly check containing interest and principal. Prior to that time it was virtually impossible for individuals to invest in mortgages.
One of the problems that holders of pass-throughs faced, however, was that homeowners generally hold the right to pay off their mortgages at any time. When interest rates fell, as they did during the Reagan era, mortgage holders found themselves receiving principal repayments earlier than planned. These cash flows then had to be invested in a lower interest rate environment. The returns on mortgage pass-throughs were, thus, quite volatile, much to the surprise of many investors who were not properly informed by their brokers of this risk.
Enter the Collateralized Mortgage Obligation or CMO. If I have ever heard on an instrument more severely maligned by the press, I don t know what it is. A CMO is issued off of a portfolio of mortgages and consists of separate claims called tranches. Some tranches receive principal only, some receive interest only. Some receive principal and interest and when fully repaid, others then step in line to receive principal and interest. Some have a limited degree of protection against principal repayments. Still others have a claim on any residual value after all tranches are paid off. There are numerous other types of tranches. Reporters have described this as though nefarious rocket scientists working away in their labs were carving your mortgages up into complicated little pieces to see who they could rip off the most. There s no question that some of these pieces are indeed complicated. Others are quite simple. The tranches bear different types of both interest rate and prepayment risk. For example, a tranche with low priority will receive only interest payments until the principal is repaid on higher priority tranches. This gives it protection against prepayments while generating some interest return. Later that protection is removed. The main point is that these tranches offer widely divergent risk-return profiles and, hence, investors interested in holding mortgage securities need not bear too little or too much risk. You simply buy the tranche that fits your desired level of risk and expected return.
There is no question that some investors have suffered painful losses by investing liquidity balances into high risk tranches. But this is a result of the investor s failure to understand what he s buying or trusting a broker who fails to fit the risk- return characteristics of the security with the investor s unique needs. (How many times have we heard that happen?)
ABSs have also been constructed with packages of receivables, especially credit card receivables and these have somewhat less of a prepayment problem.
In summary, the ABS is a significant financial innovation that has given investors a greater range of risk-return possibilities.
COMMENTS: This concludes three weeks of commentaries on instruments. I covered swaps, structured notes and asset-backed securities. I have assumed the readers of misc.invest.futures are already familiar with futures and options. So now we ve covered most of the major classes of derivatives (counting forwards as being essentially the same as options). Next week I ll begin talking about some technical issues in derivatives and over time, hopefully get to some of your requested topics.