Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Asset-backed securities (ABS) are debt-type securities that are secured by a pool of similar debt obligations or receivables. –The market for these securities arose in the early 1980s with the advent of mortgage-backed securities (MBS). Now virtually all forms of debt obligations and receivables have been securitized in the United States –For most non-corporate or non-institutional investors, mortgage- backed securities are the most familiar and accessible class of asset-backed securities. Best known sources: GNMA, FNMA, FHLMC

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 When is the use of this tool indicated? When an investor desires a relatively secure type of investment that in most cases is guaranteed by the United States Treasury or a federal agency. When the investor desires a relatively high rate of return When the investor requires a high level of cash flow –Monthly payments of interest and principal When the investor desires a high level of liquidity –Secondary market When the investor seeks to diversify his portfolio beyond stocks and corporate bonds

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 Advantages Mortgage-backed bonds are virtually risk-free in terms of return of principal and certainty of income. Provide one of the highest rates of return available from debt instruments –Interest rates on residential mortgages are usually higher than short-term money market rates Holders are usually guaranteed a monthly payment of interest and principal –Whether or not the issuer has actually collected these sums

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 Advantages Payments are usually made on the fifteenth day of the calendar month following the month in which collections on mortgages are made. There is a well-developed secondary market. –High level of liquidity Prepayment penalties –Passed on to investor as monthly income

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Disadvantages The price of mortgage-backed securities will tend to fall when market interest rates rise. Mortgage-backed securities are subject to two types of inflation risk: –The risk that the purchasing power of their income will be eroded over time, and –The risk that the purchasing power of capital received at maturity will have diminished A direct investment in mortgage-backed securities is difficult for many investors because a high minimum investment is required. –A GNMA certificate has a principal value of $25,000 at its inception.

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Disadvantages Mortgage-backed securities carry the risk that the underlying mortgages will be paid off more quickly than anticipated –The holder will receive the stated interest for a shorter time period than desired. Mortgage-backed bondholders face greater reinvestment risk than regular bondholders. –The periodic payments from mortgage-backed securities include both interest and a return of capital. –These payments must be reinvested and if interest rates have fallen, that money will be reinvested at lower rates, thus lowering future total return.

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Tax Implications Interest income is reportable as ordinary income in the year received. The portion of each monthly payment that represents the return of principal is a nontaxable repayment of the original investment. –Discount portion is included as ordinary income Prepayment penalties, assumption fees, and late payment charges passed through to the investor are ordinary income reportable in the year received.

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Tax Implications Gains on the sale of these issues are capital gains. –If purchased at a discount, the remaining unrecognized portion of the discount will be taxed as ordinary income. Amounts withheld from the investor by the issuer of the certificate to pay servicing, custodian, and guarantee fees are expenses incurred for the production of income and as such are deductible as miscellaneous itemized deductions.

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Alternatives Many large mutual fund organizations sponsor funds that specialize in mortgage-backed securities –Smaller investment requirement –Interest rate risk may be hedged in portfolio REITs offer some of the same features as mortgage- backed securities even though they are quite different in form. Collateralized mortgage obligations (CMOs) and Real Estate Mortgage Investment Conduits (REMICs)

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Where and How do I get it? Interests in mortgage-backed securities can be acquired from a brokerage firm in much the same fashion as stocks or bonds Thrift institutions Banks

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 What fees or other costs are involved? Investors can expect to pay a modest commission or service charge to the brokerage firm or bank handling the transaction. –The fee is typically $15 to $25 for each $1,000 invested. –The fee may be included in the total cost of the securities purchased rather than shown separately as a commission or service charge.

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 How do I select the best of its type? The Identity of the Issuer –A U.S. government guarantee assures the investor of the highest degree of safety of principal The Age of the Mortgages in the Pool –Payments received from older mortgages are made up of larger amounts of mortgage principal and smaller amounts of interest

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 How do I select the best of its type? The Nature of the Underlying Mortgages Included in the Pool –Safety of principal and certainty of income depend upon: The quality of the mortgages The number and size of the mortgages The distribution of mortgage maturities The geographic distribution of mortgages

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 How do I select the best of its type? The Guarantees on the Security and the Mortgages –There are four types of guarantees that are given by issuers in order to enhance their creditworthiness, including: Guarantees on interest payments Guarantees on principal payments Mortgage guarantee insurance Hazard insurance

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 How do I select the best of its type? The Risk-Return Tradeoff –The securities that provide the lowest level of risk and that offer the most prompt payment trade at a lower yield than other mortgage-backed securities. –Various private issues trade at much higher yields because of their somewhat higher risk.

Asset Backed Securities Chapter 23 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Where can I find out more about it? Wall Street Journal and other major newspapers –List mortgage-backed securities available, current prices, and the yield on each issue Larger brokerage houses –First Boston Company Handbook of Securities of the United States Government and Federal Agencies –Salomon Brothers