Asset Backed Securities
Central Florida Investment Fraud Attorney - Russell L. Forkey, Esq.
If you believe that you have lost money as a result of broker fraud, misrepresentation or negligence, in the purchase or sale of an asset backed security, call the law office of Russell L. Forkey, for your initial free consultation.
Please keep in mind that the below discussion is not complete in all material aspects. This information is being provided for educational purposes only and should not be relied upon as legal or investment advice.
An asset-backed security (ABS) is a bond backed by a pool of financial assets. For investors, it is an alternative to investing in general unsecured corporate debt. An ABS is a generic term used to describe various types of securities which are backed by almost any type of asset such as:
- credit card debt
- a company's receivables
- auto loans
- student loans
- equity cash flows
Asset backed security are usually long-term securities, while shorter term securities backed by assets are called "Asset-Backed Commercial Paper" (ABCP).
Companies that issue these loans or receivables sell them to securities dealers which package them into ABS which are then offered on the market. The utility of an asset-backed security is that it enables holders of illiquid assets, such as commercial banks, to bring them to market. An asset-backed security is created in a process called securitization. After the assets are pooled, by the securities dealers, "tranches" will be created with differing yields and seniority rights to the cash flows, and sold to investors or institutions, depending on risk profile, through the issuance of bonds. Generally, in a sequential payout structure called a waterfall, all principal payments will go to the senior tranche until those holders are fully paid off before principal payments flow down the ladder to the mezzanine, and then subordinate, tranches. Likewise, senior tranches have claim on interest payments, and interest cash flows can be diverted from the subordinate tranches to more senior tranches to make up any shortfall. To compensate the mezzanine and subordinate tranches for the increased risk of loss due to cash flow shortfalls, they receive higher interest rates than the senior tranche.
The tranching is typically done such that the most senior tranches are rated AAA by the rating agencies while the other tranches have lower ratings.
The benefit to a company in issuing an asset backed security is that it enables the issuer to transfer any risk inherent to the underlying pool of funds to whomever buys the ABS. Additionally, an asset-backed security can enable the issuer to borrow funds more cheaply than by issuing a traditional bond. This is because an asset-backed security derives its credit rating from the creditworthiness of the underlying assets, not the financial solvency of the issuing firm, as with traditional bonds. The risks associated with ABS are the same risks as those associated with bonds generally but are enhanced by the nature of the assets backing the bond. This is why these types of investments are generally sold to institutional investors.
A Special Note Regarding Mortgage Bonds and Their Difference from CMO's
The issuer of a mortgage bond has granted to the bondholder a first mortgage lien on some piece of property or possibly all the firm's property. Such a lien provides greater security to the bondholder and a lower interest rate for the issuing firm. Mortgage bonds differ from mortgage backed securities in two aspects:
- Mortgage bonds are collateralized on property of the issuer, not limited to real estate. Mortgage-backed securities are collateralized on mortgage loans.
- Mortgage bonds are serviced by cash flows from the issuer's business operations, not cash flows from the collateral. Mortgage-backed securities are serviced by cash flows from the underlying mortgage loans.
Collateralized Mortgage Obligations (CMOs)
The main innovation of the CMO instrument is the segmentation of irregular mortgage cash flows to create securities that are high-quality, short-, medium- and long-term collateralized bonds. Specifically, CMO investors own bonds that are collateralized by a pool of mortgages or by a portfolio of mortgage backed securities. The bonds are serviced with the cash flows from these mortgages, but rather than the straight pass-through arrangement, the CMO substitutes a sequential distribution process that creates a series of bonds with varying maturities to appeal to a wider range of investors.
Over the years, we have represented investors in claims, against major brokerage firms, dealing with the suitability of these types of investments for their clients and the veracity of the representations made to the client by the account executive concerning the material terms of the investment. In the latter situation, we find that most account executives do not understand all of the material information, concerning the investment, to even recommend it in the first place. But even more alarming is the risk associated with these investments, evidenced by the tranche that you purchase. A striking example of this risk was reflected, in an arbitration matter, wherein a client was sold and interest only tranche. Interest rates moved adversely to the client's position. The underlying mortgages were paid off early. The interest payments stooped. The client lost most of his original investment.