Common Misunderstandings About Asset-Backed Securities (ABS) from an Exam Point of View
When students study Asset-Backed Securities (ABS) for exams, they often face certain misunderstandings or misconceptions. These misunderstandings can lead to mistakes in answering questions or applying concepts. Let’s break down the most common misunderstandings from an exam perspective and clarify them in simple terms.
1. Misunderstanding: ABS Are the Same as Regular Bonds
Many students think that ABS are just like regular bonds issued by companies or governments. However, there’s a key difference:
- Regular Bonds: These are loans given to a company or government. The borrower promises to pay interest and return the principal amount.
- ABS: These are backed by a pool of assets (like car loans or credit card payments). The cash flows come from the repayments made by borrowers, not from a single company or government.
Why This Matters in Exams:
- If a question asks, “What is the difference between ABS and regular bonds?” you need to explain that ABS are backed by a pool of assets, while regular bonds are backed by a single entity.
2. Misunderstanding: ABS Are Risk-Free
Some students assume that ABS are completely safe because they are backed by assets. However, this is not true.
- Risk of Default: If borrowers (e.g., car loan takers) fail to repay their loans, the cash flows to ABS investors can decrease.
- Prepayment Risk: If borrowers repay their loans early, investors may get less interest than expected.
- Market Risk: Changes in interest rates or economic conditions can affect the value of ABS.
Why This Matters in Exams:
- If a question asks, “What are the risks associated with ABS?” you need to mention credit risk, prepayment risk, and market risk.
3. Misunderstanding: ABS Are Only for Big Investors
Many students think that ABS are only for large institutional investors like banks or hedge funds. However, this is not entirely true.
- Retail Investors: While it’s true that ABS are often bought by big investors, retail investors can also invest in ABS through mutual funds or ETFs (Exchange-Traded Funds) that specialize in structured finance products.
- Accessibility: In India, for example, retail investors can invest in ABS indirectly through debt mutual funds that include securitized assets.
Why This Matters in Exams:
- If a question asks, “Who can invest in ABS?” you should mention that both institutional and retail investors can invest in ABS, either directly or indirectly.
4. Misunderstanding: ABS Are Too Complex to Understand
Students often feel overwhelmed by the complexity of ABS, especially when terms like tranches, credit enhancement, and Special Purpose Vehicle (SPV) are introduced.
- Tranches: These are simply slices of the ABS with different risk and return levels. Senior tranches are safer but offer lower returns, while equity tranches are riskier but offer higher returns.
- Credit Enhancement: This is just a safety net to protect investors from losses. For example, over-collateralization means the value of the assets is higher than the value of the ABS issued.
- SPV: This is a separate company created to hold the assets and issue the ABS. It ensures that the assets are protected even if the original lender goes bankrupt.
Why This Matters in Exams:
- If a question asks, “What are tranches in ABS?” you need to explain that tranches are slices of ABS with different risk and return levels.
- If a question asks, “What is the role of an SPV in ABS?” you should explain that the SPV holds the assets and issues the ABS, protecting the assets from the lender’s bankruptcy.
5. Misunderstanding: ABS Are Only Backed by Mortgages
Some students think that ABS are only backed by home loans (Mortgage-Backed Securities or MBS). However, ABS can be backed by many types of assets, such as:
- Auto Loans: Loans given to buy cars.
- Credit Card Receivables: Payments made by credit card users.
- Student Loans: Loans taken by students for education.
- Equipment Leases: Payments from leasing machinery or vehicles.
Why This Matters in Exams:
- If a question asks, “What types of assets can back ABS?” you should mention auto loans, credit card receivables, student loans, and equipment leases, not just mortgages.
6. Misunderstanding: ABS Are Only Used in Developed Countries
Students often think that ABS are only used in countries like the US or Europe. However, ABS are also used in emerging markets like India.
- India: ABS are growing in popularity in India. For example:
- Banks securitize auto loans, home loans, and microfinance loans.
- Infrastructure projects are funded through ABS.
- Regulation: The Reserve Bank of India (RBI) regulates ABS to ensure transparency and protect investors.
Why This Matters in Exams:
- If a question asks, “Are ABS used in India?” you should explain that ABS are used in India and regulated by the RBI.
7. Misunderstanding: ABS Caused the 2008 Financial Crisis
While ABS, particularly Mortgage-Backed Securities (MBS), played a role in the 2008 financial crisis, it’s not accurate to say that ABS themselves caused the crisis.
- Root Cause: The crisis was caused by subprime mortgages (high-risk home loans) that were bundled into MBS and sold to investors. When housing prices fell, many borrowers defaulted, leading to massive losses.
- ABS Are Not Inherently Bad: ABS are a financial tool. If used responsibly, they can benefit the economy. The problem in 2008 was the poor quality of the underlying assets (subprime loans) and lack of proper regulation.
Why This Matters in Exams:
- If a question asks, “Did ABS cause the 2008 financial crisis?” you should explain that ABS played a role, but the crisis was caused by irresponsible lending and poor regulation, not by ABS themselves.
8. Misunderstanding: ABS Are Only for Banks
Some students think that only banks can create ABS. However, other institutions can also create ABS, such as:
- Non-Banking Financial Companies (NBFCs): For example, an NBFC that gives out personal loans can securitize those loans.
- Microfinance Institutions (MFIs): MFIs can securitize small loans given to rural borrowers.
- Corporates: Companies with income-generating assets (e.g., lease payments) can also create ABS.
Why This Matters in Exams:
- If a question asks, “Who can create ABS?” you should mention banks, NBFCs, MFIs, and corporates.
How to Avoid These Misunderstandings in Exams
- Understand the Basics: Start with the core concept that ABS are backed by a pool of assets, not a single borrower.
- Learn Key Terms: Make sure you understand terms like tranches, credit enhancement, and SPV.
- Use Examples: Real-life examples (like the car loan ABS example above) can help you remember the concepts.
- Practice Questions: Solve past exam questions on ABS to identify areas where you might have misunderstandings.
Conclusion
Asset-Backed Securities (ABS) are an important topic in finance, but they are often misunderstood by students. By focusing on the core concepts and clarifying common misunderstandings, you can approach exam questions on ABS with confidence. Remember to:
- Explain the difference between ABS and regular bonds.
- Discuss the risks associated with ABS.
- Mention that ABS can be backed by various types of assets.
- Highlight the role of tranches, credit enhancement, and SPV.