STRENGTHS
Investors of asset backed securities (ABSs) are subject to interest rate risk. When interest rates rise, the prices of ABS fall, and vice versa. The risk of rising interest rate will affect yields because it may influence the pace of prepayments of the underlying loans. This is normally in the case of mortgages consumer asset backed securities.
The underlying borrowers of asset backed securities may fail to make interest and principal payments when due and unable to meet other obligation such as maintenance of collaterals in the contract. As a result, investor of asset back securities may face the risk of default.
One additional type of risk involved in ABS is credit risk. Most ABSs are issued as separate tranches, which have different risks and yields. The senior tranche, class A, has the triple A credit rating. The junior tranches, class B and C, usually pay a higher yield because they have a lower credit rating and incur higher risk. The junior tranches will absorb all of the losses, up to their value before senior tranches begin to experience losses.
The incentive for banks to lend and quickly package these loans in the form of securitized assets is to remove risky assets from their balance sheet. As a result, the banks transmit the credit risk to third party investors, so that the banks receive cash in return. This allows banks to invest more of their capital in new loans or other assets and possibly have a lower capital requirement. The banks are obliged to hold a higher level of capital for loans granted to high-risk borrowers. However, thanks to securitization it is possible that banks sell a part of those and with the proceeds, lend to riskier borrowers so as to increase the expected returns of their portfolio with no change in capital requirements.
The subprime crisis is the result of the deteriorate underwriting standard in evaluating the credit worthiness of the borrowers as the banks might have shed off all the credit risk in a loan
The underlying borrowers of asset backed securities may fail to make interest and principal payments when due and unable to meet other obligation such as maintenance of collaterals in the contract. As a result, investor of asset back securities may face the risk of default.
One additional type of risk involved in ABS is credit risk. Most ABSs are issued as separate tranches, which have different risks and yields. The senior tranche, class A, has the triple A credit rating. The junior tranches, class B and C, usually pay a higher yield because they have a lower credit rating and incur higher risk. The junior tranches will absorb all of the losses, up to their value before senior tranches begin to experience losses.
The incentive for banks to lend and quickly package these loans in the form of securitized assets is to remove risky assets from their balance sheet. As a result, the banks transmit the credit risk to third party investors, so that the banks receive cash in return. This allows banks to invest more of their capital in new loans or other assets and possibly have a lower capital requirement. The banks are obliged to hold a higher level of capital for loans granted to high-risk borrowers. However, thanks to securitization it is possible that banks sell a part of those and with the proceeds, lend to riskier borrowers so as to increase the expected returns of their portfolio with no change in capital requirements.
The subprime crisis is the result of the deteriorate underwriting standard in evaluating the credit worthiness of the borrowers as the banks might have shed off all the credit risk in a loan