Yves Nosbusch

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Demystifying Asset Backed Securities

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Inflation in the euro zone remains too low, i.e., too far removed from the European Central Bank's (ECB) objective of 2%. If this situation persists over the coming months, the likelihood of unconventional monetary policy measures by the ECB increases. In particular, the ECB could launch a programme of large-scale bond purchases, known as Quantitative Easing, in the same way as the central banks of the USA, Japan and the UK. It could purchase sovereign bonds and private debt securities, notably Asset Backed Securities (ABS). These instruments have often been criticised for their role in the recent financial crisis, and the eurozone ABS market has failed to take off again since the crisis, even though losses on European ABS have actually turned out to be very limited. The aim of this article is to give an illustration of the mechanism underlying ABS. 

 

A simple idea

The basic idea is to pool a large number of individual loans and transform them into several new categories of tradable securities with a default risk which is different from the initial loans. The process can be illustrated with a simple example. Suppose we start with 100 bank loans to individuals or companies. The loans are risky because each borrower could default. To simplify things, assume that each loan is for €1 million and that, in the event of default, the creditors would lose their entire investment.

 

Illustration

 

The ABS process consists in pooling the 100 loans to create, say, two new securities: a senior tranche with a face value of €80 million and a junior tranche with a face value of €20 million (in reality there would be more than two tranches). Thus if some of the initial loans default, the losses will be passed on first to the junior tranche. For example, if 10% of the loans in our example were to default, investors in the junior tranche would take a 50% loss (€10 million out of a total €20 million investment), while investors in the senior tranche would be repaid in full. So in our example, more than 20% of the loans would have to default for investors in the senior tranche to incur a loss.

 

This example shows how the process can be used to create new securities with a different default risk than the initial loans – in this case a senior tranche with a lower default risk and a junior tranche with a higher risk. The strength of the effect depends on the correlation of the underlying loans. Another advantage of the mechanism is that the assets it produces are easier to trade because they involve higher amounts than the initial loans.

 

Impact on the financing of the real economy

A number of institutional investors, including insurers and pension funds, are required to purchase only tradable securities of high credit quality. By creating tradable senior tranches with lower default risk, the ABS process thus enables these institutions to play a bigger part in financing the real economy while at the same time allowing them to diversify their portfolios more broadly. It also enables banks to reduce the size of their balance sheets and to free up capital, which becomes available to extend more credit to households and companies. In addition, banks can show their commitment to loan selection and monitoring criteria by keeping a portion of the junior tranches on their balance sheets. 

 

Role of the ABS in the crisis

The idea of reviving the ABS market has been met with mixed reactions, since ABS played a key role in the recent financial crisis. That said, the problems in 2007 and 2008 stemmed mainly from ABS backed by risky subprime mortgages in the USA and from more exotic securities, including collateralised debt obligations (CDOs). In the latter case, the ABS process was applied a second (or even a third) time to existing tranches, thereby increasing the risk and complexity of these products. In contrast, simple and transparent ABS have been widely used since the 1980s without triggering systemic problems. 


Article completed on 9 May 2014 by Yves Nosbusch, Chief Economist of the Bank
Published in the Luxemburger Wort (in French) on 9 May 2014
 

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