Asset-backed securities are financial instruments that are backed by a group of assets, such as loans, mortgages, or credit cards. These assets generate cash flows from the borrowers who pay interest and principal. The cash flows are then passed on to the investors who buy the ABS.
The process of creating an ABS is called securitization. It involves selling the assets to a special entity, which then packages them into a portfolio and issues securities based on the portfolio. The securities are divided into different risk levels, or tranches, depending on the quality and priority of the assets. The higher the risk, the higher the return, but also the higher the chance of default.
The main benefits of ABS are that they provide more investment opportunities, diversify the risk, and free up capital for the original lenders. The main drawbacks are that they have prepayment risk, meaning that the borrowers may pay off their loans early and reduce the expected cash flows, and default risk, meaning that the borrowers may fail to pay their loans and cause losses to the investors.
Basic Theory:
Asset-backed securities are created through a process known as securitization. Financial institutions bundle a portfolio of assets, create a special purpose vehicle (SPV), and issue securities backed by the cash flows generated by these underlying assets. The cash flows from the assets are used to make periodic payments to the investors in the securities.
Procedures:
- Asset Selection: Choose a pool of assets to be securitized. These could be loans, mortgages, or
other receivables. - Special Purpose Vehicle (SPV): Create a legal entity (SPV) to hold the assets and issue the
securities. - Transfer of Assets: Transfer the selected assets to the SPV, which then issues securities
representing claims on the cash flows from these assets. - Tranching: Securities are often divided into tranches with different levels of risk and return.
Senior tranches have higher priority in receiving payments but offer lower yields, while junior tranches offer
higher yields but are more susceptible to losses. - Issuance: The securities are sold to investors in the market, providing the institution with
funds.
Comprehensive Explanation with Excel Formulas:
Excel Table:
Create a table in Excel with columns for Loan Amount, Interest Rate, Monthly Payment, and Remaining Balance.
| Loan Amount | Interest Rate | Monthly Payment | Remaining Balance |
|---|---|---|---|
| $10,000 | 5% | =PMT(5%/12, 60, 10000) | =FV(5%/12, 36, -B2, 0, 0) |
| $15,000 | 5% | =PMT(5%/12, 60, 15000) | =FV(5%/12, 36, -B3, 0, 0) |
Cash Flow Calculation:
Calculate the monthly cash flow for each loan using the PMT function and the remaining balance using the FV
function.
Tranching:
Decide the division between senior and junior tranches. Let’s say $70 million for Senior and $30 million for
Junior.
Cash Flow to Senior Tranche:
Use the SUMPRODUCT function to calculate the cash flow to the Senior tranche based on the allocated amount and the
cash flows from individual loans.
=SUMPRODUCT(Senior_Allocation, Monthly_Payments)
Cash Flow to Junior Tranche:
Similarly, use the SUMPRODUCT function for the Junior tranche.
=SUMPRODUCT(Junior_Allocation, Monthly_Payments)
Scenario Calculation:
- Total Monthly Cash Flow: $5 million
- Senior Tranche Allocation: $70 million
- Junior Tranche Allocation: $30 million
- Cash Flow to Senior Tranche: $3.5 million (70% of total cash flow)
- Cash Flow to Junior Tranche: $1.5 million (30% of total cash flow)
Result:
In this scenario, investors in the Senior tranche receive $3.5 million in monthly cash flows, while investors in
the Junior tranche receive $1.5 million.
Other Approaches:
- Sensitivity Analysis: Perform sensitivity analysis using Excel’s Data Table feature to evaluate
the impact of changing interest rates or default rates on the cash flows to different tranches. - Monte Carlo Simulation: Use Excel to perform a Monte Carlo simulation to model various
economic scenarios and assess the potential risks associated with the ABS.
