Asset-Backed Securities

Asset-backed securities enable depository institutions, finance companies, and other corporations to "liquefy" their balance sheets (i.e., raise cash by borrowing against assets) and develop new sources of capital. Assets such as credit cards, automobile loans, and home equity loans are packaged as the collateral for intermediate-term (i.e., maturity of one to five years) securities and sold in the public markets or as private placements. Other assets that have been "securitized" in this way include loans for mobile homes, pleasure boats, and recreational vehicles.

Issuers reap many advantages by securitizing assets rather than keeping them on their books. By packaging their portfolios of credit card receivables as securities, major commercial banks, for example, have been able to reduce the amount of capital they would otherwise have to maintain under new, stringent capital guidelines mandated by bank regulators. As the leading bank issuer of credit cards, Citibank has also emerged as the largest issuer of securities backed by credit card receivables. Sears, Roebuck has also employed the technique aggressively. In 1991 it issued more than $5 billion in securities backed by the Discover card and retail-store credit card receivables, as well as loans for recreational vehicles and autos. Led by the General Motors Acceptance Corporation (GMAC), the finance affiliates of the Big Three U.S. automakers have securitized billions in auto loans, giving the car companies an additional source of funds at attractive rates. Other corporations have converted trade and lease receivables into securities, though in much smaller volumes than the mainstay credit card and auto loan transactions.

Investor acceptance of asset-backed securities has grown as the market matured. Consequently, these securities now trade at interest-rate spreads over Treasury bills that make them a relatively low-cost source of funding for many companies. Credit card-backed securities, which in 1991 represented the largest single category of new issues (41 percent of the dollar volume), have settled into a trading range of 65 to 105 basis points (0.65 to 1.05 percentage points) over Treasurys with comparable maturities. Issues collateralized with auto debt, the second-biggest market component (30 percent), trade at a spread of just 60 to 80 basis points, while offerings supported by home equity loans, the third largest (21 percent) category, move in a range of 120 to 160 basis points.

Not surprisingly, asset-backed securities evolved out of the mortgage-backed securities market, which developed in the seventies when interest rates surged and thrift institutions found themselves saddled with residential mortgages that were earning less than what they were paying for deposits. Compared with mortgage-backed securities, asset-backed issues have been relatively unaffected by swings in interest rates. The reason is that the car loans and other loans backing the securities have shorter maturities than mortgages, and therefore people are less likely to refinance when interest rates fall. In that respect, asset-backed securities resemble noncallable bonds.

This new market was born in early 1985, when the Sperry Lease Finance Corporation, a special-purpose organization set up by Sperry Corporation (now Unisys), sold to institutional investors $192.4 million in fixed-rate notes collateralized by computer leases. Managed and structured by First Boston Corporation, that deal enabled Sperry to offset rising marketplace resistance to its conventional debt, which was hindering the company's efforts to lease new equipment. Another early milestone came in October 1986, when GMAC issued $4 billion in notes backed by automobile loans.

Although the legal devices used to package nonmortgage assets are very similar to those used for mortgage-backed securities, there are several key differences. For one thing, mortgage-backed securities are guaranteed by U.S. government agencies. In contrast, issuers of asset-backed securities typically gain a top investment-grade rating by selling the assets into a "bankruptcy-proof" entity, called a special-purpose company or trust, and cushioning investors against loss of principal with one or more kinds of credit support. This so-called "credit enhancement" takes a variety of forms, including letters of credit from top-rated commercial banks, third-party guaranties, reserve funds, recourse to the parent company, and cash collateral accounts, which lately have overtaken letters of credit as the method of choice for major public transactions. So far, these securities have stood up extremely well on the rare occasions when issuers have run into rough financial seas. The concept passed a crucial test in mid-1991, when Miami's troubled Southeast Bank was forced to pay out early on a $300 million credit card issue. According to Walid Chammah, managing director of First Boston's asset finance unit, "Investors haven't been hurt in any transaction that was structured and rated."

Structuring these securities requires a careful analysis of complex tax, accounting, and legal issues. Generally, issuers seek to package the securities so that the receivables will be deemed to have been sold, rather than pledged, for purposes of bankruptcy, regulatory, and generally accepted accounting principles (GAAP). That way, issuers receive "off-balance-sheet" accounting and regulatory treatment, which is significantly more favorable than "on-balance-sheet" treatment.

The market enjoyed a banner year in 1991, but Wall Streeters think that year's results might represent the high-water mark, at least for the near term. According to Asset Sales Report, a trade newsletter, the volume of new public asset-backed debt reached a record $50.6 billion (106 issues) in 1991, up about 18 percent from the $42.8 billion (93 issues) level the year before. Among lead managers First Boston ranked first in dollar volume, with $13.9 billion (22 issues), followed by Merrill Lynch with $11.7 billion (31 deals) and Salomon Brothers with $8.4 billion (10 issues).

Investment bankers do not expect this performance to continue. One reason is that so much credit card debt has already been securitized that not much unsold inventory is left. Moreover, the recession has slowed consumer borrowing and sparked concerns about increases in delinquencies. Citicorp, for one, expected its 1992 new issue volume to drop to less than $6 billion from the $9 billion level in 1991, according to The Wall Street Journal. To some extent, however, the expected decline in volume of credit card issues could be offset by growth in other, newer types of securities, such as those backed by home equity loans, "floor plan" loans used to finance automobile dealer inventories, and trade and lease receivables. With the collapse of the U.S. commercial real estate market, commercial banks and insurers, as well as the Resolution Trust Corporation, the government agency charged with disposing of the assets of failed thrifts, are beginning to securitize commercial real estate loans to get them off their books.

Investment bankers also think the fledgling but erratic overseas asset-backed securities market might eventually pick up some steam. In 1991, according to Investment Dealers' Digest, dollar volume of new European asset-backed issues fell by more than half, to $2.6 billion (nine issues) from $5.8 billion (eighteen issues) the year before. One reason for the slower development of the European market is that European banks are under less pressure than their American cousins to reduce leverage. Additionally, the legal and regulatory apparatus governing these transactions is still in its infancy.