In the Insolvency and Bankruptcy Board of India’s exam for Registered Valuer for the Securities and Financial Asset class, Asset backed Securities (ABS) is part of Valuation Application chapter from which around 1-2 MCQ are expected relating directly to ABS or other concepts related to this. Therefore, for the purpose of Registered Valuer exam of IBBI, one need to understand the concept of ABS properly so that MCQ in exams can be solved without any error.

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can’t be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans, or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren’t available in any other investment.

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use to make more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default. Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

 Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

 Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

Collateralized loan obligations (CLOs) are CDOs made up of bank loans. Collateralized bond obligations (CBOs) are composed of bonds or other CDOs. Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt.  Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs. Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn’t qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

From this piece of information, you must have realised by now that how important this concept of ABS is from the point of view of IBBI registered valuer Examination. Therefore, Student’s unfamiliarity with ABS concept, its application and rationale assuming that these areas are complex would not be appreciated and may cost the aspirant a lot. Therefore, I would like to urge you all to study this concept precisely and adequately. You can easily score those 1 to 2 marks in valuer examination that will make the difference between passing and failing.

What is eventually important for you is to study strategically and work on your weak areas with complete dedication so that you could pass the IBBI registered valuer examination. And for passing that examination with a minimum of 60% marks, these small and easy areas make a lot of difference. RVMOCKTEST.ONLINE is there to help you in this path of becoming a Registered Valuer by making you exam ready. You can check your preparedness and identify your mistakes, by appearing in online mock tests of RVMOCKTEST.ONLINE that will boost your confidence and increase your chances of clearing in one single shot!!

Best wishes from RVMOCKTEST.ONLINE