Asset-backed securities: The determinants of yield spreads

Asset-backed securitization has enjoyed rapid growth in its rather short existence as a public market. These nonmortgage, nongovernment-guaranteed asset-backed issues have created a new source of fixed income securities for investors and a new source of liquidity for banks and other lending firms. This study examines the determinants of asset-backed securities' (ABS) equilibrium yield spread over Treasury, using a cross-section of primary market issue prices.;The process of converting illiquid assets to traded securities involves a complex set of institutional arrangements and structures that create an intricate set of risks for the investor. These institutional arrangements, structures, and risks are analyzed as a precursor for specifying a model of the determinants of pricing. This model extends models previously used in pricing studies of corporate bonds and mortgage-backed securities.;There is no standard data source for these securities, so there have been no previous studies of how these securities are priced. A major contribution of the study is the assembly and analysis of a substantial dataset that describes the pricing and characteristics of over 700 ABS at issue. Ordinary least square regressions are utilized in the pricing analysis, which includes issues from 1985 through 1992. This analysis finds that ABS pricing (absolute and relative yield spreads) is rational and prices reflect premiums for default risk, interest rate and reinvestment risk, and marketability. As one would expect in a rapidly evolving market, institutional forms have changed frequently, and new ones have been added, over the sample period. To some degree, the market has required premiums for the unfamiliar or new and discounted for experience. ABS in general do not exhibit negative convexity and are not subject to excessive prepayment risk. Although the complicated structures utilized to separate the risk of the collateral from the risk of the originator are effective, as indicated by the preponderance of AAA rated issues, investors nonetheless require information in addition to credit rating concerning an issue's pool and/or servicing when pricing the issue.