An asset-based security is something like a collateralized debt obligation (CDO) (ABS). It’s similar to a loan or bond in that it’s backed by a collection of financial instruments, such as bank loans, mortgages, credit card receivables, airplane leases, smaller bonds, and occasionally even other ABSs or CDOs. The interest earned by the CDO is garnered by the institutional investors that acquire it, and this portfolio serves as collateral for that income.
What is the process of an ABS transaction?
When a person takes out a loan, the debt becomes an asset on the lender’s balance sheet. The lender can then sell these assets to a trust or “special purpose entity,” which will bundle them into an asset-backed securities that can be traded publicly.
Are asset-backed securities inherently risky?
Finally, if the underlying assets are in default, some risks may occur. The risk of default is spread across a wide variety of assets because each security only contains a percentage of each underlying asset. During an economic crisis, however, if the underlying assets are of poor quality, the security may see numerous defaults.
Asset-Backed Securities and the Financial Crisis
Many banks created asset-backed securities backed by mortgages, often known as mortgage-backed securities, during the 2008 Global Financial Crisis (MBS). Many investors, however, were unaware that the securities were backed by subprime mortgages with a significant risk of default.
Because securities were unregulated at the time, banks issued a massive amount of securities with no monitoring from the government. The securities were then given AA or AAA ratings by the major rating agencies, indicating that they were considered safe investments.
Many institutional investors, such as pension funds, bought the bonds without realizing the possibility of default. When borrowers became unable to make payments and defaulted on their mortgages, the underlying assets became worthless, causing the mortgage-backed security market to collapse and wipe out trillions of dollars in investments.
What exactly is the distinction between ABS and MBS?
Within the fixed-income industry, asset-backed securities (ABS) and mortgage-backed securities (MBS) are two of the most prominent asset classes. MBSs are made up of mortgages that are pooled and sold to interested investors, whereas ABSs are made up of non-mortgage assets. Credit card receivables, home equity loans, student loans, and auto loans are typically used to support these assets. Since its inception in the 1980s, the ABS market has grown in importance in the US debt market.
What is asset-backed trading, and how does it work?
In the energy and resources sector, asset-backed trading (ABT) has become commonplace. The strategy raises a number of transfer pricing (TP) and tax issues that are relevant to all taxpayers who are considering or have already implemented an ABT model.
What is asset-backed trading?
An ABT model is one in which a company controls assets associated to the production, transportation, and processing of a commodity rather than the item itself. This allows the company to maximize value by utilizing considerable arbitrage gains that would otherwise be unavailable.
The transition to this paradigm provided greater value in absolute terms for organizations that already owned assets and helped mitigate the impact of a commodity price decline. After seeing decreased profit levels on their trading activities, a number of new asset traders have adopted a strategy of accumulating assets.
One or more of the following types of arbitrage would normally be present in trading for a certain commodity shipment.
Time arbitrage
The discrepancy between the present and future prices is exploited by a trader. This will include the trader purchasing and keeping the commodity, then selling it on the forward date in a market where the future price is greater than the spot price (a contango market) (a cash and carry arbitrage). The opposite would happen in a market where the future price is discounted to the present (a backwardated market) (a reverse cash and carry arbitrage).
Geographic arbitrage
The existence of various prices in distinct geographic markets gives rise to this form of arbitrage. A trader, for example, would buy heating oil in the northern hemisphere during the summer when prices are low and sell it in the southern hemisphere during the winter when prices are higher.
Technical arbitrage
By processing a commodity of a higher-priced grade or adjusting its refining/processing processes to use an input commodity of a lower-priced grade, an ABT organization can take advantage of price differentials for different quality of a commodity (for example, heavy oil and light oil).
Production arbitrage
Organizations with production assets may be able to change production schedules to reduce production when the relevant commodity price is low and increase production when the price is higher.
Transfer pricing implications
To evaluate the TP consequences, first identify the regulated transactions, then consider whether they should be recognized in accordance with the guidance in Chapter I of the OECD’s TP rules for MNEs. The most appropriate pricing technique is then chosen and implemented to support arm’s-length pricing in accordance with the TP guidance’s Chapters II and III.
Delineation of related-party transactions
The goal of the analysis is to determine the success factors for the specific sector to which the trading activities are related (paragraph 1.34), and then to determine what each group entity conducts, and thus what related-party transactions exist (paragraph 1.35). The sale or purchase of things, the provision of services, finance associated to commercial activities, and potentially intangible payments, such as for the use of software, are all examples of ABT transactions.
The OECD’s five comparability factors are used to accurately delineate the relevant related-party transactions:
Although this article focuses mostly on the functional analysis, it is crucial to highlight that in the TP analysis, when there is a difference between agreements and the parties’ actual conduct, the latter takes precedence. To ensure proper tax treatment and avoid lengthy conversations during tax audits, it is critical to have accurate written intercompany agreements in place.
Functional analysis
In order to identify the relevant transactions, it is necessary to understand the overall functions performed by the entities within the ABT organization, as well as the functions and related risks that pertain to individual arbitrage opportunities. It is vital to determine where the product will be stored until the future contract is fulfilled, who owns the storage facility, and who retains legal title to the product for time arbitrage trades that take advantage of contango markets.
The first challenge in such a circumstance is determining whether another group entity is providing services to the trading business. The second point to consider is the impact of permanent establishment (PE). When a trading entity retains title to a product and stores it in another nation, this could result in the creation of a PE for the trading entity in that country, with profit being attributed to the PE as a result. Whether or not a PE is created depends on the facts of the case, the storage country’s domestic tax law for recognizing taxable presence, and whether or not the storage country has adopted the BEPS-updated version of Article 5 of the OECD’s model tax convention in its income tax treaty with the trading country.
The essential question in geographic arbitrage trading is who identifies the arbitrage opportunity and begins the trade (and hence assumes the risk).
For example, suppose an organization has trading desks in different legal companies in the UK and the US, and it decides that selling a UK-sourced commodity in the US market would be beneficial. The question is whether the UK trading desk identified the opportunity and launched the deal, and thus bears the associated risks (with the US business providing just support/logistics services for the trade), or whether the US entity recognized the opportunity and initiated the trade. If both scenarios occur, it will be important to distinguish between them on a regular basis in order to establish the appropriate transaction types and pricing for any given deal.
If a geographic arbitrage deal does not involve a group entity in the foreign nation, it must be assessed whether the trader’s activity will result in the formation of a PE in that country.
It is crucial to determine whether the arbitrage opportunity is found by the trading entity as part of a larger optimisation job, or whether it is identified by the processing entity for quality arbitrage deals.
Similarly, when it comes to production arbitrages, it’s crucial to figure out whether the production side of the company has control over the timing and quantity of production beyond the bare minimums, or whether the trading entity does.
The preceding explanation is predicated on the assumption that the entity conducting risk-related duties is assuming those risks. Only if the entity has both risk control and the financial capacity to accept the risk would this be the case. If not, this could result in the creation of new specified transactions involving the entity with control/financial capability.
For example, if the UK firm in the geographic arbitrage scenario above lacked the financial capacity to incur a trade loss, it would be required to determine which group entity would finance such a loss and characterize the relevant intercompany transaction accordingly.
Asset-backed trading adds value by maximizing the use of infrastructure involved with the production, transportation, and processing of the relevant commodity, as well as knowledge about the commodity’s markets. The first stage in performing a functional analysis is to determine which group companies and third parties hold or lease the relevant tangible assets within the commodity value chain. It’s also important to find funding sources, especially if a trading business lacks the financial capacity to absorb the risks it’s taking. The intangible assets that allow the tangible assets to be optimized must next be identified. According to paragraph 6.6 of the OECD rules, an intangible is:
The traders’ and production and processing asset owners’ know-how, IT systems (including access to trading platforms and developed algorithms), processes, and data are all examples of intangible assets that are relevant to an ABT business, according to Chapter VI of the OECD rules.
The next stage is to determine which entities are responsible for developing, enhancing, maintaining, protecting, and exploiting (DEMPE) such intangibles. It is then possible to determine whether an intangible asset is a transaction in and of itself (such as the licensing of trading algorithms developed by one group entity) or merely a comparability factor in another transaction (such as the licensing of trading algorithms developed by another group entity) (for example, employee know-how).
Because of the rising computerization of trade and optimization required for ABT, as well as ongoing innovations (e.g. blockchain, trading algorithms, asset data utilization, and artificial intelligence), identifying all economically important intangible assets must be carefully considered.
Recognition of delineated transactions
An adequately described transaction may be discarded or potentially substituted by an alternative, according to paragraph 1.122:
Rather than formal companies, many ABT models are based on regional or worldwide trade books. As a result, trades can be set up that profit on a total book basis but result in a non-arm’s-length result for one or more of the legal organizations involved. It is a practical problem for such organizations to put in place processes to ensure that the legal entity TP criteria for trades are met without jeopardizing the traders’ ability to close deals on time.
Pricing of transactions
The precise transaction kinds and associated fact patterns will determine which pricing methods should be utilized to test the specified transactions. For many commodities transactions, the comparable uncontrolled price (CUP) technique, for example, may be appropriate (see paragraph 2.18).
A transaction in which an entity delivers trading services to another company, either directly or indirectly, as part of a netback pricing calculation for the sale of items requires extra caution. A key question is whether a one-sided approach (such as the transactional net margin method, or TNMM) can be justified, or whether a profit split method is required (PSM). The latter may be relevant to ABT models (see paragraph 2.115), either because they are potentially highly integrated value chains, or because both parties may be making unique and valuable contributions, such as trading algorithms by the trader and data from another legal entity.
If a PSM is acceptable, it must be determined what profit is to be split and how it will be split, as well as any legal concerns that may arise in some countries, such as the potential of a presumed partnership.
For each organization, determining which approach is most appropriate for trading services will be based on facts. The potential tax risk can be enormous, especially when trading services are provided to an organization subject to a high-tax commodity regime. This emphasizes the importance of proper intangible identification and transaction demarcation in order to establish a defendable TP stance for the pricing methodologies used.
Overall, ABT models necessitate a thorough examination of the facts to guarantee appropriate TP policies are defined for the relevant transactions, as well as their systematic execution.
Nick Pearson-Woodd is a Deloitte Norway director headquartered in Oslo. Nick is a licensed tax counselor in the United Kingdom with nearly 20 years of experience in direct tax. He has been with Deloitte’s transfer pricing unit in Norway for the previous nine years.
Nick has worked with clients in a variety of industries, including the oil and gas business. He is in charge of Deloitte Norway’s documentation and operational TP services, and he has managed various TP, advice, documentation, operational TP, and controversy projects for outbound and inbound international corporations.
Nick specializes in offering technically sound BEPS-compliant solutions that are both aligned with a company’s value chain and strategic drivers and easy to deploy.
Marius Basteviken is a partner in the transfer pricing practice of Deloitte Norway. He has more than 12 years of expertise offering guidance on a wide variety of TP issues as an experienced international tax and TP counsel for various multinational firms. This covers services such as consulting, implementation, compliance, and dispute resolution. Marius has worked in a variety of businesses.
Marius has served as an advisor and project manager for a number of important tax audits in Norway. Price methods for physical goods transactions, tax deductibility for centralised services, correctness of financial assessments, interest deductions, and pricing of guarantee provisions have all been the subject of these audits.
Marius became a partner at Deloitte Norway in September 2017. He was the head of TP at another Big Four accounting firm in Norway before joining Deloitte. Marius has a law degree as well as a business degree. He is a seasoned lecturer and the author of numerous essays that have appeared in national and international journals.
Is a bond backed by a mortgage a bond?
MBS (mortgage-backed securities) are bonds backed by mortgages and other real estate debts. They are generated when a number of these loans are pooled together, usually with comparable qualities. For example, a bank that provides home mortgages would round up $10 million in mortgages. The pool is subsequently sold to a federal government agency, such as Ginnie Mae, or a government sponsored enterprise (GSE), such as Fannie Mae or Freddie Mac, or to a securities business, to serve as collateral for the new MBS.
The bulk of MBSs are issued or guaranteed by government agencies such as Ginnie Mae or GSEs such as Fannie Mae and Freddie Mac. MBS are supported by the issuing institution’s promise to pay interest and principal on their mortgage-backed securities. While Ginnie Mae’s guarantee is backed by the US government’s “full faith and credit,” GSE guarantees are not.
Private companies issue a third type of MBS. These “private label” MBS are issued by subsidiaries of investment banks, financial institutions, and homebuilders, and their creditworthiness and ratings may be significantly worse than government agencies and GSEs.
Use caution when investing in MBS due to the general complexity of the product and the difficulty in determining an issuer’s trustworthiness. Many individual investors may find them unsuitable.
Unlike traditional fixed-income bonds, most MBS bondholders receive interest payments monthly rather than semiannually. This is for a very excellent cause. Homeowners (whose mortgages form the MBS’s underlying collateral) pay their payments monthly rather than twice a year. These mortgage payments are the ones that end up with MBS investors.
There’s another distinction between the revenues from MBS and those from, say, a Treasury bond. The Treasury bond pays you solely interest, and when it matures, you get a lump-sum principal payment, say $1,000. A MBS, on the other hand, pays you both interest and principal. The majority of your cash flow from the MBS comes from interest at first, but as time goes on, more and more of your earnings come from principle. When your MBS matures, you won’t get a lump-sum principal payment because you’ll be getting both interest and principal installments. You’ve been getting it in monthly installments.
Because the original “pass-through” structure reflects the fact that homeowners do not pay the same amount each month, MBS payments (cash flow) may not be consistent month to month.
There’s one more thing to note about the portions you’ve been receiving: they aren’t the same every month. As a result, investors who prefer a predictable and constant semiannual payment may be concerned about the volatility of MBS.
Pass-Throughs: Pass-throughs are the most basic mortgage securities. They are a trust-based system for collecting mortgage payments and distributing (or passing through) them to investors. The bulk of pass-throughs have maturities of 30 years, 15 years, and 5 years, respectively. While most are backed by fixed-rate mortgage loans, the securities can also be made up of adjustable-rate mortgage loans (ARMs) and other loan combinations. Because the principal payments are “passed through,” the average life is substantially less than the stated maturity life, and it fluctuates based on the paydown history of the pool of mortgages underpinning the bond.
CMOs (short for collateralized mortgage obligations) are a sophisticated sort of pass-through investment. CMOs are made up of multiple pools of securities, rather than transmitting interest and principal cash flow to an investor from an usually like-featured pool of assets (for example, 30-year fixed mortgages at 5.5 percent, as is the case with traditional passthrough securities). These pools are known as tranches or slices in the CMO world. There might be dozens of tranches, each with its own set of procedures for distributing interest and principal. Prepare to do a lot of investigation and spend a lot of time researching the sort of CMO you’re contemplating (there are dozens of distinct varieties) and the rules that control its income stream if you’re going to invest in CMOs, which are normally reserved for knowledgeable investors.
On behalf of individual investors, many bond funds invest in CMOs. Check your fund’s prospectus or SAI under the titles “Investment Objectives” or “Investment Policies” to see if any of your funds invest in CMOs, and if so, how much.
To summarize, both pass-throughs and CMOs differ from typical fixed-income bonds in a number of respects.
What is the value of asset-backed securities?
“The procedure of offering asset-backed securities in the primary market in the United States is similar to that of issuing other securities, such as corporate bonds, and is governed by the Securities Act of 1933 and the Securities Exchange Act of 1934, as amended.” Standard SEC registration and disclosure requirements apply to publicly traded asset-backed securities, as well as the filing of periodic financial statements.”
“Trading asset-backed securities in the secondary market works in a similar way to trading corporate bonds and, to a lesser extent, mortgage-backed securities.
The majority of trading takes place in over-the-counter marketplaces, with security-by-security telephone quotes.
There do not appear to be any publicly available measures of trading volume or the number of dealers who trade in these assets.”
“According to the Bond Market Association, there were 74 electronic trading platforms for trading fixed-income securities and derivatives in the United States and Europe at the end of 2004, with 5 platforms for asset-backed securities in the United States and 8 in Europe.”
“According to market participants, many asset-backed securities are not liquid and their pricing are opaque when compared to Treasury and mortgage-backed securities.”
This is largely due to the fact that asset-backed securities are not as standardized as Treasury or even mortgage-backed securities, and investors must weigh the various structures, maturity profiles, credit enhancements, and other elements of an asset-backed security before trading it.”
A spread to a similar swap rate is frequently cited as the “price” of an asset-backed securities.
For example, a benchmark issuer might quote a credit card-backed, AAA-rated security with a two-year maturity at 5 basis points (or less) over the two-year swap rate.”
“In fact, market participants sometimes regard the highest-rated credit card and automotive securities as having a default risk similar to that of the highest-rated mortgage-backed assets, which are reportedly viewed as a substitute for default-free Treasury securities.”