Asset-Backed Security vs Mortgage-Backed Security: The Pool

Take one structure and change what sits in the pool. The contents of the pool are the entire distinction. Home loans make a mortgage-backed security; receivables of any other kind make an asset-backed one. Everything around the pool holds still: the vehicle, the jobs, the pieces, the order a loss travels. A home loan borrower may return principal early, so what moves is when the money comes back.

Two names that sound like two machines turn out to be one machine holding two different kinds of contents. One machine holding two kinds of contents changes what the question even is, and the change is worth sitting with for a moment. A comparison usually means listing features on the left and features on the right and counting the differences. Here almost every line on the left is the same line as the one facing it, and the counting stops being interesting. One narrow question is left: change the contents, and what downstream actually notices?

The answer to that question is one number, and it is a length of time rather than an amount of money. Everything below builds up to it. Most people arrive from a search on one of the two names rather than on both, so the build starts by defining each instrument on its own, without leaning on the other.

What is an asset-backed security, without mentioning the other one?

An asset-backed security is a claim on pooled receivables that are not home loans, held inside a structure that exists for that pool and nothing else, and funded by pieces that get paid in a fixed order. Three things are doing work in that sentence, so take them one at a time. A pool, meaning many small amounts owed rather than one large one. A structure that holds nothing else, so whatever happens to the lender that made those loans, the receivables sitting in the structure are not part of the argument. And pieces that are an order rather than shares. The order is the part that catches most readers out on first meeting.

Made concrete: Sarvani Receivables Trust, an invented structure, is read here as equipment loan receivables, instalments owed by small businesses that bought machines. Its pool comes to Rs 1,200 crore. Funding it are three pieces. The senior piece is the large one, at Rs 960 crore. Beneath it the mezzanine piece takes Rs 180 crore. The equity piece, at Rs 60 crore, is the smallest thing in the structure and the one that matters most to how this works. The three pieces add back to Rs 1,200 crore exactly. Checking that addition is the first thing to do on any structure. A funding side that does not close on the pool means one of the numbers has been misread. Turned into shares of the pool, the same three give 80.0 per cent, 15.0 per cent and 5.0 per cent, closing on 100.0. Worth computing once and then setting aside: shares describe size, and size is not what decides where a shortfall goes.

Now the part that is not addition. The three pieces do not each hold a slice of every rupee owed. The pieces stand in a queue. If borrowers in the pool fail to pay, the shortfall lands on the equity piece until its Rs 60 crore is gone, then on the mezzanine piece until its Rs 180 crore is gone, and only after both of those on the senior piece. So the senior piece has Rs 240 crore of other people's money standing under it before it feels anything, and Rs 240 crore set against a Rs 1,200 crore pool is 20.0 per cent of the whole thing.

The definition just given is complete. The definition names what is inside, what holds it, how it is funded and what happens when something goes wrong, and none of that needed the words home loan. A reader who came only for what an asset-backed security is has the answer at the end of this block.

What is a mortgage-backed security, without mentioning the other one?

A mortgage-backed security is a claim on pooled home loans, held inside a structure that exists for that pool and nothing else, and funded by pieces that get paid in a fixed order. Set that against the definition above: past the opening words, one phrase has been swapped and every other word is the same. The repetition is the finding.

Read Sarvani Receivables Trust the second way and its pool becomes home loans: instalments owed by households against houses they live in. Nothing on the funding side notices. Rs 1,200 crore is what the pool comes to, exactly as before. Each of the three pieces keeps the size it had. Underneath the topmost piece, Rs 240 crore of other money is still in the way of any shortfall.

A home loan brings a set of features about the loan itself that an equipment instalment does not, and those features are worth naming carefully because two of the three are red herrings for this comparison. First, a home loan runs a long time, often decades, against one household's income. Second, it is secured on the house. Third, and this is the one that matters here, the borrower ordinarily holds a right to hand back principal before its due date, in part or in whole. The right to hand principal back belongs to the person paying, not the person receiving. The holder of a mortgage-backed security has therefore agreed to a schedule the other side can shorten.

Notice what that third feature is a statement about. The feature is not a statement about losing money. Nobody defaulted, nothing was written off, and every rupee promised is still going to turn up. The feature is a statement about the obligorThe person or business on the paying end of a receivable. A pool is made of their instalments, and the pool has as many obligors as it has loans. holding a lever over the calendar. The consequences of pulling that lever, and what they cost the holder, make a subject on its own and are covered separately.

What is identical between the two, and how much of the whole does that cover?

Line the two instruments up against seven things worth comparing and six of the seven come back with the same entry written twice. Not similar entries. The same entry. Set out what a reader would actually want to know about either one and the list runs like this: what holds the pool, who does what around it, what the funding pieces are, how big they are, how much money stands beneath the topmost piece, where a shortfall lands, and what the pool contains. Only the last of those seven produces two different answers.

Work through them. The pool sits inside a vehicle that exists for that pool and holds nothing else, under both readings. Somebody moved the receivables in. Somebody collects the instalments as they fall due. A third party keeps the structure for the people who bought the pieces. All three of those are jobs rather than businesses, and all three read the same under either reading. The pieces are a queue rather than a set of shares, under both readings. The senior piece measures Rs 960 crore in both, the mezzanine piece Rs 180 crore in both, the equity piece Rs 60 crore in both. A shortfall climbs from the bottom of that queue, under both readings.

Here the identity stops being a list and becomes arithmetic that can be checked. Suppose the pool loses 12.0 per cent of what it is owed. On Rs 1,200 crore that is Rs 144 crore. The equity piece takes the first Rs 60 crore and is used up in full. The remaining Rs 84 crore lands on the mezzanine piece. The mezzanine piece had Rs 180 crore to give, so 46.6667 per cent of it is consumed and the rest survives. The senior piece receives none of it. The subtraction never asked what the receivables were, so the identical run on the home loan reading gives Rs 60 crore, Rs 84 crore and nothing.

Put the same split another way and it becomes easier to hold: five twelfths of that loss stops at the equity piece and the other seven twelfths goes to the mezzanine piece. Both fractions are properties of the three sizes and the queue. Nothing about a house, a machine, a household or a workshop enters the calculation at any point.

So what is actually different, and where does the difference show up?

The pool differs, and the consequence of that difference lands in exactly one place, the calendar rather than the loss. The claim compresses the whole comparison, so it earns some unpacking.

Start with the pool itself. A home loan runs a long stretch of years against a single household's income and is secured on the house. Other receivables run to their own terms, and those terms are written into each pool's paperwork rather than being a property of the category: equipment instalments, a shop's card settlements and a set of loans against gold all sit under the same broad heading and behave nothing like each other. So the honest statement of the difference is narrow. One pool is home loans. The other pool is whatever the transaction documentsThe bundle a structure is written in: what was transferred, who collects, who gets paid in what order, and what is to happen if something is missed. say it is, and the documents are where that is found.

Now the consequence. The borrower on a home loan ordinarily holds a right to hand principal back early, and money returning at a date the holder did not pick is the characteristic difficulty of a mortgage-backed security. The shape of that difficulty is worth noting. The difficulty is not that less arrives. The difficulty is that the arrival date is not fixed by the schedule set out at the start. PrepaymentA borrower handing principal back before the date it fell due, either in part or in one go. What follows from it, and what it costs a holder, is covered separately. is the name for the event, and the event on its own costs nobody a rupee of principal.

The number a reader uses to hold all of that in one hand is the weighted average lifeThe average of the dates on which principal arrives, with each date weighed by how much money turns up on it. Computing one for any schedule is covered separately.. Take Rs 1,200 crore of principal and declare that it returns on four annual dates, Rs 300 crore arriving each time. The weighted sum is 3,000 crore-years, and dividing by Rs 1,200 crore gives 2.50 years. Now declare a faster shape: three instalments of Rs 400 crore. The weighted sum is 2,400 crore-years and the answer is 2.00 years. The gap is 0.50 years.

A repayment speed is a property of a particular pool, and no pool has been observed, so both of those schedules are declared rather than measured off anything. The pair demonstrates something worth stating flatly: every rupee came back in both shapes, nobody lost anything in either, the three pieces did not move, and one summary number still shifted by half a year. Half a year is the entire mechanical difference between the two instruments, and it is a time rather than an amount.

Does a loss land differently on one of them?

The order a loss travels is the part readers most expect to differ between the two instruments, and it is the part that differs least. Nothing about a house changes where a shortfall goes. Nothing about a workshop's machine changes it either. In both readings the shortfall starts at the bottom of the queue and climbs, and in both readings Rs 240 crore has to disappear first, with the topmost piece feeling nothing at all until it has.

Sameness of the queue matters for learning the subject, not just for the instruments. The queue is portable across pools and the pool is not portable across queues. A queue learned properly once carries into a structure built on toll receipts, on card settlements, on gold loans or on home loans, and the funding side reads straight away. One instrument learned thoroughly instead has to be started again the next time the contents change.

Readers reach for a likelihood at exactly this point, so one caution belongs right here. The queue settles who absorbs before whom. The queue settles nothing whatever about how often anybody absorbs anything. An order of absorption and a frequency of absorption are two different quantities, and only the first is fixed by the sizes and the order. Frequency needs a distribution of losses, a view on whether the borrowers in a pool fail together or separately, and a schedule of periods.

What does all of this look like at the scale of two stalls?

Two people run stalls on the same street. Each keeps takings in a tin box, and each has written on the inside of the lid, in the same handwriting, the order in which the box gets emptied: the supplier first, the helper second, whatever is left belongs to the owner. The boxes are the same size. The orders are word for word the same. Over a month the two boxes take in the same amount.

The first stall sells tea, and every customer settles at the counter before walking away. The second sells on a monthly account, and any customer may clear the whole account whenever they feel like it. Same box, same written order, same total. But only the second owner spends the month wondering when the money will actually turn up, and only the second owner has to decide what to do with a large settlement that arrives three weeks early.

The written order inside the lid never had to be rewritten for the second stall, and that is exactly the finding this comparison keeps arriving at from different directions. The arrival pattern changed, and an arrival pattern is a fact about the customers rather than about the box or the order. A pool of home loans is the second stall.

Which facts are actually read about each pool?

Four facts have to be read out of the paperwork whichever pool is in front of the reader, and the home loan pool carries one more line that the other side does not. The four are the total the pool is owed, how many separate receivables make it up, how large the biggest single one is, and the schedule the money is contractually due on. None of those four is difficult to find and all four are easy to skip.

The second and third mean something only as a pair. A pool of Rs 1,200 crore made of forty thousand small instalments and a pool of Rs 1,200 crore made of eighty large ones are not the same object, and no single number on the funding side distinguishes the two. A difference of that kind is what concentrationHow much of a pool sits with one borrower, one region or one line of business. Two pools with identical totals can be built very differently, and the count and the largest single receivable are where that shows. means in practice, and it is a pool question rather than a piece question.

The extra line on the home loan side is what the papers say about handing principal back early: whether the borrower may do it, on what terms, and how that gets told to the people holding the pieces. The extra line is about timing and reporting rather than about anything being lost. The reporting half of it is set by an authority and revised, so the current wording sits with that authority.

A fifth thing is often wanted and not always given: the stretch of time the lender held each loan on its own books before it travelled into the structure. The name for that stretch is seasoningThe stretch of time a lender keeps a loan before it is allowed to move into a structure. How long that must be is set by an authority and is revised, so it is named here and left unwritten., and the required period is set rather than chosen, so seasoning belongs among the items settled elsewhere rather than among the figures above.

How does a credit desk actually use this on a Tuesday?

An offer document of two hundred printed sides lands on a desk on Tuesday morning and somebody has to say something useful about it by Thursday. Nobody has time to read all of it, and this comparison is what decides the reading order. The funding side, meaning the pieces, their sizes and the queue, can be summarised in four lines and checked with a pen: do the pieces close on the pool, how much stands beneath the topmost one, what share of the pool is that, and where does a stated loss land. Checking the funding side is an hour of work, and the same hour whatever the pool holds.

Everything the desk cannot shortcut lives in the pool. The reading list runs: what are the receivables, how many, how large is the biggest, what is the schedule, and on a home loan pool, what does the paperwork say about early repayment and about telling holders when it happens. Two structures with identical funding sides can be very different objects, and every bit of that difference is in the pool section rather than the funding section.

The line a careful desk refuses to write is the ranking line, and refusing it is a professional act rather than a hedge. Saying that one pool is safer than another needs two figures: what comes back from borrowers who stop paying, and how often they stop. Where a pack carries neither, the honest note says the structures were compared on construction and were not placed in an order. A desk that writes a ranking anyway has manufactured a conclusion, and everything downstream of that note inherits it as though it had been measured.

Households do a smaller version of the same thing. Nobody publishes how a lender behaves when a payment is missed, so somebody choosing between two lenders can compare what is written down and nothing beyond it. Comparing what is documented and saying plainly that the rest is not documented is the same discipline at a different scale.

Can either one be called the safer of the two?

Neither instrument is placed ahead of the other here, and the reason is a shortage of evidence rather than a shortage of nerve. Placing one ahead would mean knowing, for both pools, how much gets lost and how often that happens. Neither figure is in hand for either kind of pool, and inventing a plausible one would produce a ranking that reads as though it had been measured.

Construction can be compared, and construction has been compared in full and in both directions. The sizes are fixed. The queue is fixed. The arithmetic of a stated loss is fixed and runs identically on both readings. Not one of those is a statement about how likely anything is, and the difference between the two kinds of statement is the difference between an account that can be trusted and one that merely sounds authoritative.

A reader expects a likelihood to arrive at exactly this point, so say it plainly. A likelihood would need a distribution of losses, a view on whether the borrowers in a pool fail together or independently, and a schedule of periods, and the comparison above rests on none of the three. The queue says who absorbs before whom, and stops.

Where the one moving part on this subject lives

Exactly one relationship on this subject rewards being dragged: the one between a repayment schedule and the average date money arrives. The control for it sits with the treatment of repayment timing.

A table that reads across in one look and a pair of boxes with nothing inside them carry the rest of the comparison, and neither of those improves by being made to move. The last of the nine questions asks for an instrument never described above to be sorted. Sorting an unseen instrument is the only real test of whether the sorting rule landed.

Where these figures came from

Every rupee amount here began as an invention and stayed one. Four amounts were chosen so the addition closes and the subtraction can be done in the head, and everything else was worked out from those four rather than looked up. No transaction was read. No pool was examined. Past losses on pools of either kind were never observed, so no series was consulted and none was estimated to stand in for a missing one. Both repayment schedules are stated here as declarations and were measured off nothing: they exist so that one number can be made to move while everything else is held still. The same discipline runs through the blanks. Where a requirement would normally be quoted, the item is named and the current wording is left with the authority that sets it. A quoted requirement that has since been revised is wrong rather than merely old.