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The wizards of ABS

Right, with that little bit of steam blown away, let us look away from morons on beaches to morons in markets and especially at the archaic world of asset-backed securities (ABS); that financial juggernaut which constitutes the largest category of debt in the world. Right from the emergence of the turbo-charged ABS in the late 1980s and early ’90, one particular question has always gnawed at my insides – what exactly is an ABS when the collateral underpinning it actually proves non-existent? [Readers note – I have referred to these securities as asset-backed securities, which is the umbrella term for residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) and so on; most of the actual assets referred to in this article are RMBS. Plus I couldn’t think of any wicked puns with the useless abbreviation RMBS].

The answer, dear readers, is that the security becomes an unsecured (or non-collateralized) obligation of the issuer. So as a creditor you effectively go from the chap who has a charge on specific assets to being the muppet who stands in the same queue as all the other creditors of the issuer. You thought you were better placed because there was no “credit” risk from the issuer, ie you didn’t have to worry about whether the issuer of the security was safe or not – what really mattered was that you had strong financial collateral with which to recover the value of your investment if ever the payments stopped coming. If the collateral is exposed as a lie you of course become the same as everyone else.

Tickle me Elmo, what can I say.

To be sure, my initial questions back in those days pertained mainly to the issue of ABS that were backed by homes in, say, hurricane-prone Florida and what happens when the physical collateral simply disappeared in a mighty gust of wind. In the kernel of that question though, lay a deeper quandary, namely the possibility that documentation and legal problems could always undermine the actual quality of an ABS.

Interestingly, the notion of disappearing collateral was the reason the ABS market virtually never took route in “emerging” markets – “Pah!” they said. “No one can trust these Chinese and Indian guys to document their collateral properly; and we can never enforce on the actual assets anyway.” Thus it was that the ABS market remained firmly rooted in the “developed” countries such as the United States, United Kingdom, France and Spain.

So to summarize, developed markets could create and sell ABS because of two reasons:
a. The rule of law allowed creditors to seize collateral whenever payments were stopped;
b. Documentation was straightforward and clear; with layers of checks and balances to prevent errors of commission and omission.

Alright Dorothy, stand by to witness the Wizard.

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