11/9/2020 Asset-Backed (ABS) vs. Mortgage-Backed Securities (MBS): What’s the Difference?

INVESTING ALTERNATIVE INVESTMENTS

Asset-Backed (ABS) vs. Mortgage-Backed

Securities (MBS): What’s the Difference?
By ALEXANDRA YAN | Updated Mar 1, 2020

Asset-Backed Securities (ABS) vs. Mortgage-Backed Securities

(MBS): An Overview
Asset-backed securities (ABS) and mortgage-backed securities (MBS) are two of the most
important types of asset classes within the fixed-income sector. [1] [2] MBS are created from
the pooling of mortgages that are sold to interested investors, whereas ABS is created from
the pooling of non-mortgage assets. These securities are usually backed by credit card
receivables, home equity loans, student loans, and auto loans. The ABS market was
developed in the 1980s and has become increasingly important to the U.S. debt market. [3]
Despite their apparent similarities, the two types of assets possess key differences.

The structure of these types of securities is based on three parties: the seller, the issuer, and
the investor. Sellers are the companies that generate loans for sale to issuers and act as the
servicer, collecting principal, and interest payments from borrowers. ABS and MBS benefit
sellers because they can be removed from the balance sheet, allowing sellers to acquire
additional funding.

Issuers buy loans from sellers and pool them together to release ABS or MBS to investors, and
can be a third-party company or special-purpose vehicle (SPV). [4] Investors of ABS and MBS
are typically institutional investors that use ABS and MBS in an attempt to obtain higher
yields than government bonds and provide diversification.

KEY TAKEAWAYS
Asset-backed securities (ABS) are created by pooling together non-mortgage assets,
such as student loans. Mortgage-backed securities (MBS) are formed by pooling
together mortgages. 
ABS and MBS benefit sellers because they can be removed from the balance sheet,
allowing sellers to acquire additional funding.
Both ABS and MBS have prepayment risks, though these are especially pronounced
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for MBS. 

ABS also have credit risk, where they use senior-subordinate structures (called
credit tranching) to deal with the risk.
Valuing ABS and MBS can be done with various methods, including zero-volatility
and option-adjusted spreads. 

Asset-Backed Securities (ABS)

There are many types of ABS, each with different characteristics, cash flows, and valuations.
Here are some of the most common types. [5]

Home Equity ABS

Home equity loans are very similar to mortgages, which in turn makes home equity ABS
similar to MBS. The major difference between home equity loans and mortgages is that the
borrowers of a home equity loan typically do not have good credit ratings, which is why they
were unable to receive a mortgage. Therefore, investors need to review borrowers' credit
ratings when analyzing home equity loan-backed ABS.

Auto Loan ABS

Auto loans are types of amortizing assets, and so the cash flows of an auto loan ABS include
monthly interest, principal payment, and prepayment. Prepayment risk for an auto loan ABS
is much lower when compared to a home equity loan ABS or MBS. Prepayment only happens
when the borrower has extra funds to pay the loan. 

Refinancing is rare when the interest rate falls because cars depreciate faster than the loan
balance, resulting in the collateral value of the car being less than the outstanding balance.
The balances of these loans are normally small and borrowers won't be able to save
significant amounts from refinancing at a lower interest rate, giving little incentive to
refinance.

Credit Card Receivable ABS

Credit card receivables are a type of non-amortizing asset ABS. [6] They don't have scheduled
payment amounts, while new loans and changes can be added to the composition of the
pool. The cash flows of credit card receivables include interest, principal payments, and
annual fees.

There is usually a lock-up period for credit card receivables where no principal will be paid. If
the principal is paid within the lock-up period, new loans will be added to the ABS with the
principal payment that makes the pool of credit card receivables staying unchanged After
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principal payment that makes the pool of credit card receivables staying unchanged. After
the lock-up period, the principal payment is passed on to ABS investors.
Mortgage-Backed Securities (MBS)
Most mortgage-backed securities are issued by Ginnie Mae (the Government National
Mortgage Association), Fannie Mae (the Federal National Mortgage Association) or Freddie
Mac (the Federal Home Loan Mortgage Corporation), which are all U.S. government-
sponsored enterprises. [2]

MBS from Ginnie Mae are backed by the full faith and credit of the U.S. government, which
guarantees that investors receive full and timely payments of principal and interest. In
contrast, Fannie Mae and Freddie Mac MBS are not backed by the full faith and credit of the
U.S. government, but both have special authority to borrow from the U.S. Treasury if
necessary.

Mortgage-backed securities can be purchased at most full-service brokerage firms and some
discount brokers. The minimum investment is typically $10,000; however, there are some
MBS variations, such as collateralized mortgage obligations (CMOs), that can be purchased
for less than $5,000. [7] [8] Investors that don't want to invest directly in a mortgage-backed
security, but want exposure to the mortgage market may consider exchange-traded funds
(ETFs) that invest in mortgage-backed securities. 

Notable ETFs investing in MBS include the iShares MBS ETF (MBB) and the Vanguard
Mortgage-Backed Securities Index ETF (VMBS). [9] [10] ETFs trade similar to stocks on
regulated exchanges and can be sold short and purchased on margin. [11] Like stocks, ETF
prices fluctuate throughout each trading session in response to market events and investor
activities.

Special Considerations 
Both ABS and MBS have prepayment risks, though these are especially pronounced for MBS.
Prepayment risk means borrowers are paying more than their required monthly payments,
thereby reducing the interest of the loan. [12] Prepayment risk can be determined by current
and issued mortgage rate difference, housing turnover, and mortgage rates. 

For instance, if a mortgage rate begins at 9%, drops to 4%, rises to 10% and then falls to 5%,
homeowners would likely refinance their mortgages the first time the rates dropped.
Therefore, to deal with prepayment risk, ABS and MBS have tranching structures to help
distribute prepayment risk. [13] Investors can choose a tranche based on their own
preferences and risk tolerance.

ddi i l f i ki l di i di i k
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One additional type of risk involved in ABS is credit risk. ABS has a senior-subordinate
structure to deal with credit risk called credit tranching. The subordinate or junior tranches
will absorb all of the losses up to their value before senior tranches begin to experience
losses. Subordinate tranches typically have higher yields than senior tranches due to the
higher risk incurred. [14]

Asset-backed and mortgage-backed securities can be quite complicated in terms of their

structures, characteristics, and valuations. Investors have access to these securities through
indexes such as the U.S. ABS index. For those who want to invest in ABS or MBS directly, it's
imperative to conduct a thorough amount of research and weigh your risk tolerance prior to
making any investments.

ABS vs. MBS Example 

It is important to measure the spread and pricing of bond securities and know the type of
spread that should be used for different types of ABS and MBS. If the securities do not have
embedded options such as call, put, or certain prepayment options, the zero-volatility
spread (Z-spread) can be used as a measurement. The Z-spread is the constant spread that
makes the price of a security equal to the present value of its cash flow when added to each
Treasury spot rate. [15]

For example, we can use the Z-spread to measure credit card ABS and auto loan ABS. Credit
card ABS does not have any options, making the Z-spread an appropriate measurement.
Although auto loan ABS do have prepayment options, they're not typically exercised, making
it possible to use the Z-spread for measurement.

If the security has embedded options, then the option-adjusted spread (OAS) should be used.
The OAS is the spread adjusted for the embedded options. To derive the OAS, the binomial
model can be used if cash flows depend on current interest rates but not on the path that led
to the current interest rate. [16]

Another way to derive the OAS is through the Monte Carlo model, which needs to be used
when the cash flow of the security is the interest rate path-dependent. MBS and Home Equity
ABS are types of interest rate path-dependent securities where OAS from the Monte Carlo
model would be used for valuations. However, this model can be quite complex and needs to
be checked for accuracy throughout its usage. [17]

ARTICLE SOURCES

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Related Terms
Asset-Backed Security (ABS)
An asset-backed security (ABS) is a debt security collateralized by a pool of assets. more

Midgets Definition
Midgets is slang for 15-year GNMA bonds. more

Option-Adjusted Spread (OAS) Definition

The option-adjusted spread (OAS) helps investors compare the yield of two different fixed-income
offerings that have embedded options. more

Securitization: How Debt Makes You Money

Securitization is the process by which an issuer designs a marketable financial instrument b pooling
various financial assets into one group. more

Collateralized Debt Obligation (CDO) Definition

A collateralized debt obligation (CDO) is a complex financial product backed by a pool of loans and
other assets and sold to institutional investors. more

Residential Mortgage-Backed Security (RMBS) Definition

Residential mortgage-backed securities are a type of security created from residential debt such as
mortgages, home-equity loans & subprime mortgages. more

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