Asset-backed Security - Advantages and Disadvantages

Advantages and Disadvantages

A significant advantage of asset-backed securities for loan originators (with associated disadvantages for investors) is that they bring together a pool of financial assets that otherwise could not easily be traded in their existing form. By pooling together a large portfolio of these illiquid assets they can be converted into instruments that may be offered and sold freely in the capital markets. The tranching of these securities into instruments with theoretically different risk/return profiles facilitates marketing of the bonds to investors with different risk appetites and investing time horizons.

Asset backed securities provide originators with the following advantages, each of which directly adds to investor risk:

• Selling these financial assets to the pools reduces their risk-weighted assets and thereby frees up their capital, enabling them to originate still more loans.
• Asset-backed securities lower their risk. In a worst-case scenario where the pool of assets performs very badly, "the owner of ABS (which is either the issuer, or the guarantor, or the re-modeler, or the guarantor of the last resort) might pay the price of bankruptcy rather than the originator." In case the originator or the issuer is made to pay the price of the same, it amounts to re-inventing of the lending practices, restructuring from other profitable avenues of the functioning of the originator as well as the norms of the issuance of the same and consolidation in the form of either merger or benchmarking (internal same sector, external different sector).

This risk is measured and contained by the lender of last resort from time to time auctions and other Instruments that are used to re-inject the same bad loans held over a longer time duration to the appropriate buyers over a period of time based on the instruments available for the bank to carry out its business as per the business charter or the licensings granted to the specific banks. The risk can also be diversified by using the alternate geographies, or alternate vehicles of investments and alternate division of the bank, depending on the type and magnitude of the risk.

The exposure to these refinanced loans and other types of the "bad credit (Type II) decisions, particularly in the banking sector, unscrupulous lending", or the adverse selection of credits is hedged against the sellers of the same, or the re-structures of the same. Thinking of securitization (insurance) as a panacea of all ills of a bad credit decision might spell the hedging of the risk in the form of transfer of the "hot potato", from one issuer to the other Without the actual asset against which the loan is backed reaching an upswing in the value either By the virtue of demand supply mismatch being addressed

• The economy productivity or the business cycle being reversed from the downturn to the upturn (Monetary and fiscal maeasures)
• More buyers than sellers in the market
• A breakthrough innovation.

On a day to day basis the transferring of the loans from the

• Sub-ordinate debt (freshly made and highly collateralized debt) to the
• Sub-ordinate realizable
• Sub-ordinate non-realizable

Senior as well as bad (securitized) debt might be a better way to distinguish between the assets that might require or be found eligible for re-insurance or write - off or impaired against the assets of the collaterals or is realized as a trade-off of the loan granted against or the addition of goods or services.
This is totally built up in any bank based on the terms of these deposits, and dynamic updation of the same as regards to the extent of the exposure or bad credit to be faced, as guided by the accounting standards, and adjudged by the financial and non-market (diversifiable) risks, with a contingency for the market (non-diversifiable) risks, for the specified types of the accounting headers as found in the balance sheets or the reporting or recognition (company based declaration of the standards) of the same as short term, long term as well as medium term debt and depreciation standards.

The issuance of the accounting practices and standards as regards to the different holding patterns, adds to the accountability that is sought, in case the problem increases in magnitude.

• The originators earn fees from originating the loans, as well as from servicing the assets throughout their life.

The ability to earn substantial fees from originating and securitizing loans, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. This is an intrinsic structural flaw in the loan-securitization market that was directly responsible for both the credit bubble of the mid-2000s (decade) as well as the credit crisis, and the concomitant banking crisis, of 2008.

"The financial institutions that originate the loans sell a pool of cashflow-producing assets to a specially created "third party that is called a special-purpose vehicle (SPV)". The SPV (securitization, credit derivatives, commodity derivative, commercial paper based temporary capital and funding sought for the running, merger activities of the company, external funding in the form of venture capitalists, angel investors etc. being a few of them) is "designed to insulate investors from the credit risk (availability as well as issuance of credit in terms of assessment of bad loans or hedging of the already available good loans as part of the practice) of the originating financial institution".

The SPV then sells the pooled loans to a trust, which issues interest bearing securities that can achieve a credit rating separate from the financial institution that originates the loan. The typically higher credit rating is given because the securities that are used to fund the securitization rely solely on the cash flow created by the assets, not on the payment promise of the issuer.

The monthly payments from the underlying assets—loans or receivables—typically consist of principal and interest, with principal being scheduled or unscheduled. The cash flows produced by the underlying assets can be allocated to investors in different ways. Cash flows can be directly passed through to investors after administrative fees are subtracted, thus creating a “pass-through” security; alternatively, cash flows can be carved up according to specified rules and market demand, thus creating "structured" securities."

This is an organized way of functioning of the credit markets at least in the Developed Primary non-tradable in the open market, company to company, bank to bank dealings to keep the markets running, afloat as well as operational and provision of the liquidity by the liquidity providers in the market, which is very well scrutinized for any "aberration, excessive instrument based hedging and market manipulation" or "outlier, volumes" based trades or any such "anomalies, block trades 'company treasury' based decision without proper and posterior/prior intimation", by the respective regulators as directed by the law and as spotted in the regular hours of trading in the pre-market/after-hours trading or in the event based specific stocks and corrected and scrutinized for insider trading in the form of cancellation of the trades, re-issuance of the amount of the cancelled trades or freezing of the markets (specific securities being taken off the trading list for the duration of time) in event of a pre-set, defined by the maximum and minimum fluctuation in the trading in the secondary market that is the over the counter markets.

Generally the Primary markets are more scrutinized by the same commission but this market comes under the category of institutional and company related trades and underwritings, as well as guarantees and hence is governed by the broader set of rules as directed in the corporate and business law and reporting standards governing the business in the specific geography.