ABS Fundamentals & Asset Classes

Securitisation is a funding technology — its purpose is to separate the cash flows generated by a pool of assets from the credit risk of the entity that originated them. Once separated, those cash flows can be pledged to investors who would never lend directly to the originator.

The mechanism: an originator sells a defined pool of receivables to a Special Purpose Vehicle (SPV) via a true sale — meaning the assets legally leave the originator's balance sheet and cannot be reclaimed by its creditors. The SPV funds this purchase by issuing structured notes (tranches) to investors. Collections flow from the loans through a trust account, then through a priority waterfall to noteholders.

Three motivations drive this: regulatory capital relief (removing loans reduces risk-weighted assets), lower funding cost (a AAA senior tranche borrows cheaper than the originator's unsecured bonds), and investor diversification (access to insurers and pension funds that can't hold unrated corporate debt). From the investor's side: the appeal is structural seniority — a senior noteholder doesn't care if the originator files bankruptcy as long as the true sale holds.

The four product labels share the same structural skeleton — pooled assets, SPV, tranched notes — but differ in collateral type, waterfall logic, and investor base in ways that matter operationally.

ABS: non-mortgage consumer and commercial receivables — auto, credit cards, student loans, equipment, marketplace loans. Collateral is amortising (auto) or revolving (credit cards). Key variables: CPR and CDR on the underlying loans.

MBS: backed by residential (RMBS) or commercial (CMBS) mortgages. Prepayment dynamics are more extreme — borrowers refinance aggressively when rates fall. Agency MBS carries a government guarantee; non-agency does not.

CLO: pools 150–250 senior secured leveraged loans to LBO companies. The manager actively trades the portfolio during a reinvestment period. OC and IC tests redirect cash if coverage ratios break — a waterfall feature absent in static consumer ABS.

CDO: pools debt instruments — bonds, ABS tranches, or other CDO tranches. The CDO-squared structures of 2005–2007 concentrated systemic risk. Modern new-issue CDOs are rare. Do not conflate with CLOs.

Auto Loans & Leases — ~50% of annual ABS issuance. Fixed-rate, secured, WAL 1.5–2.5 years on 60-month loans due to prepayments. Key risk variables: LTV at origination, FICO distribution, seasoning, and used car prices (which set recovery rates). Prime (FICO 700+) CDRs: 0.5–1%; non-prime (FICO 550–650): 4–8% base, spiking to 20%+ in stress.

Credit Cards — the only major consumer ABS with a revolving pool, structured as a master trust. New receivables continuously added. Key metrics: monthly payment rate (MPR), purchase rate, gross yield, delinquency rate. Revolving period → accumulation → rapid amortisation. Early amortisation events (EAEs) triggered if MPR or excess spread drops below a floor.

Student Loans — two completely different risk profiles. FFELP (legacy, government-guaranteed 97–100%) is effectively credit-risk-free. Private student loans: no guarantee, income-driven repayment risk, extension from 10 to 25 years possible. Recovery is via wage garnishment — 5–15%.

"Esoteric" ABS is the fastest-growing segment — anything outside auto, card, or student loan. The structural logic is always the same: find a predictable contractual cash flow and securitise it. What differs is the collateral type, recovery mechanism, and economic cycle correlation.

Equipment ABS: secured by physical equipment (construction, healthcare, tech). WAL 2–4 years. Recovery via repossession and remarketing. Trade Receivables: short-duration (30–90 days), revolving corporate receivables. Key risks: obligor concentration and dilution (credits/returns reducing balances). Insurance Premium Finance: borrowers fund commercial premiums; on default, the servicer cancels the policy and recovers the unearned premium from the insurer — 85–95% recovery rates. Marketplace Lending / BNPL: unsecured, no physical collateral, highly correlated with consumer credit cycles and originator underwriting quality.

Two legal opinions must hold simultaneously: the true sale opinion and the non-consolidation opinion. If either fails, the SPV's assets re-enter the originator's estate and ABS investors become unsecured creditors.

The true sale opinion confirms the transfer is a sale, not a secured loan. Courts examine: whether the seller retains meaningful recourse for defaults, whether fair value was paid, and whether transaction documents use sale language throughout.

The non-consolidation opinion addresses substantive consolidation — a court's power to merge entities that are so intertwined they should be treated as one. The SPV must: maintain its own books, hold board meetings, pay its own expenses, never commingle funds with the originator, and be structured as an "orphan" (equity held by a charitable trust).

Most public ABS structures insert a Depositor between the originator and the SPV — two true sale opinions required, two layers of insulation.

CPR (Conditional Prepayment Rate) — annualised rate at which borrowers pay off loans ahead of schedule. A 20% CPR means 20% of the outstanding pool balance will prepay in the next 12 months. CPR compresses WAL. Monthly equivalent: SMM = 1 − (1 − CPR)^(1/12).

CDR (Conditional Default Rate) — annualised rate at which loans default. Applied to the current outstanding balance (not original). CDR reduces pool size and generates losses. Net credit loss = CDR × (1 − Recovery Rate).

WAL (Weighted Average Life) — the average time in years until each dollar of principal is returned, weighted by amount. Investors price notes to WAL (via Discount Margin to WAL), not to stated maturity. High CPR = shorter WAL. High CDR = slightly longer WAL on the surviving pool.

The PSA curve is the mortgage prepayment convention — 100% PSA ramps from 0% CPR at month 1 to 6% CPR at month 30, then holds flat. Consumer ABS uses simpler flat CPR assumptions. Any CPR number is a model convention, not a prediction.

Private credit funds use ABS for three reasons: leverage, term funding, and investor diversification. The economics only work if the blended cost of ABS notes is meaningfully below the yield on the underlying loans.

The standard path is warehouse-to-term. The fund builds a pool in a warehouse facility (a revolving bank line, 6–24 months). Once large enough and seasoned, the fund refinances into a term ABS — issuing 3–7 year notes to institutional investors at a fixed spread. The warehouse is repaid; the fund retains the equity tranche (retained residual).

The ROE math: pool yield 10%, blended ABS note cost 6% → excess spread 4%. At 85% advance rate, equity = 15%. ROE = 4% / 15% ≈ 27% gross. Every 1% increase in advance rate adds ~0.15–0.25% more ROE on equity. This is why advance rate negotiation matters so much.

Compared to a plain bank revolving credit facility: ABS provides longer tenor, no margin call on individual loans (only on pool-level triggers), and access to institutional investors that can't hold bank loans directly.

Public and private ABS share the same structural mechanics but differ in six ways that directly affect how a fund monitors, reports on, and manages a private deal.