Asset-backed securities: a misunderstood asset?

Mention the term asset-backed securities (ABS) at a trustee meeting and those around the table are likely to wince, laugh or think you are mad. In fact, the asset class’s reputation since the financial crisis has been so poor that it probably does not even get a look-in on the agenda at most investment committee meetings.

“To get back into that [pre-crisis] position would require massive amounts of leverage to be pumped back into the marketplace and we are not seeing that, nor are we likely to.”

Ben Hayward

ABS came out of the crisis battered and bruised; a large part of which the US sub-prime market was responsible for. A steadily increasing US property market in 2006/07 spawned lax underwriting standards and lenders began pushing down into the less creditworthy areas of the market, freely issuing loans to those who would not ordinarily score high enough in the credit rating metrics to get one. Banks then packaged these highly- leveraged loans, or collateralised debt obligations (CDOs) and sold them out to the market, which meant they were no longer sitting on their balance sheets. Some of these CDOs were leveraged so highly that a default in the underlying market, such as sub-prime in the US, saw the entire structure blow up.

Naturally, the assets suffered losses and liquidity dried up so it became harder to get rid of them as securities. ABS was subsequently neglected because big central banks and ratings agencies were forced to support the struggling banks rather than ABS structures. All this deterred investors from entering the asset class, many of whom regarded it as junk.

Badly tarred reputation

Insight Investment fixed income portfolio manager Shaheer Guirguis says: “It does suffer from a credibility issue and the US sub-prime market has a lot to answer for that. People lost the ability to believe in the ratings agencies and the ability to believe a skilled manager could take advantage of what is in my mind one of the opportunities of this cycle.”

According to Russell Investments head of fixed income research Adam Smears, the asset class was “tarred with a pretty nasty brush” after the crisis but more recently there have been whisperings of ABS appearing on investors’ radars, albeit viewed through a cautionary lens, for a number of reasons.

Firstly, it is important to bear in mind that ABS is a wide-encompassing asset class covering a large spectrum of credit ratings. Other than the much-maligned mortgage-backed securities (MBS), ABS can also include cashflows from credit card receivables and auto loans through to more esoteric forms of business securitisation, such as securing an income from pubs.

According to data by Royal Bank of Scotland as at 30 September 2012, the size of the European investable ABS market was €747bn, split between residential mortgages (48%); CDOs (18%); commercial mortgages (16%); consumer and other (10%); and whole business (8%).

Laurence Kubli, co-manager of the Swiss & Global Asset Management Julius Baer ABS fund, explains: “Market participants think about it being junk and of bad quality, but senior tranches of ABS carry very limited credit risk. The misunderstanding comes because ABS is not known enough and does not have a group of lobbyists putting the asset class ahead.”