Asset Backed Securities or ABSs are bonds secured Pools by the stream of principle and interest repayments from individual loans with similar or identical structural and sectoral characteristics issued into the capital markets. The periodic issuance of ABS permits the originator of the loans to recapitalize itself from the capital markets and continue to originate additional loans. While commercial banks have always been able to use this technique for shifting assets off their balance sheets and as a relatively in-expensive means of funding, this technique can also be used by other non-bank institutions which originate loans, such as mortgage companies, micro-finance institutions, and the like. This financial technology got its start decades ago in the housing sector with the development of residential mortgage backed securities by Fannie Mae and Freddie Mac, and has since been applied at some point or other to virtually every loan asset class imaginable, including  standard credit card receivables and, occasionally, for pools of health care receivables.

Collateralized Debt Obligations (CDOs) and Collateralized Bond Obligations began as relatively simple  pools of corporate loans or bonds. However, in recent years, the underlying collateral of CDOs has come to include any or all manner of ABS transactions, as well, so many recently-issued CDOs can be thought of as pools of pools of loans. And in the last few years, a new class of CDOs appeared called CDO-Squared transactions: these CDOs of CDOs can often be pools of pools of pools of loans.

A single unifying principle in the development of most ABS and CDO structures is the creation of layers (“tranches“) of credit quality, with the highest rated tranches being protected by structural features such as more over-collateralization than junior tranches, and “spread accounts” which capture the arbitrage profits resulting from the difference between the interest rates charged on the underlying loans and the interest rate paid to investors in the ABS and CDOs. The creation of two or more tranches also permits those selling the ABSs and CDOs to access different investor classes, each with a different risk/reward profile for same overall transaction. This ability to target multiple investor classes means that larger ABS and CDO transactions won’t have to pay as large a size-related interest rate premium as they would have had to do if the same sized deal had only one tranche/one credit rating.

Complex probabilistic cash flow models using multi-variate stress testing with “Monte Carlo” and similar programs have increasingly come to dominate the credit evaluation, structuring and credit rating processes. The increasing prowess of modeling professionals (the “quants” in financial market parlance) and increasing computing power at their disposal has permitted the development of increasingly complex structures. However, the quality of models of this kind is entirely dependent on the quality of data and the accuracy of the model’s portrayal of the transaction’s legal provisions with respect to the flow of funds to service each distinct tranche of debt.

The current ABS and CDO marketplace is in turmoil due chiefly to the crisis in the sub-prime, Alt-A and other segments of the mortgage market, the facts that much of the data used in the models was suspect due to the explosive growth in “no-document” mortgages and over-reliance on FICO scores alone to evaluate the borrowers’ ability and willingness to pay, rapidly increasing incidence of outright fraud, and the fact that the models’ structures frequently didn’t accurately reflect the legal structure, especially in cases where events of default occur and the flow of funds is legally required to change in response. Despite the current turmoil, some ABS transactions are being successfully closed in such long-established sectors as credit card receivables and auto loans. Some prime mortgage and a few Alt A mortgage transactions are also being successfully underwritten and closed, as are substantial quantities of Fannie Mae and Freddie Mac mortgage-backed transactions.

Because most classes of ABS transactions other than those tied to sub-prime and other less than prime residential mortgages have continued to perform well, most financial analysts familiar with the field expect the current turbulence to subside, with a gradual return to normal levels of issuance in the months ahead.

As a general asset class, healthcare receivables have always presented particular difficulties for those who sought to pool them and create ABS transactions for them. In addition, a major scandal and collapse of one major firm which had successfully sold several healthcare receivable transactions, Towers Financial, made capital markets investors even more wary starting in the mid-1990’s.  Another scandalous collapse occurred in 2002 with the discovery of major fraud at National Century Financial Enterprises, which had been the nation’s largest cash flow lender to healthcare providers and largest issuer of health care receivables ABS transactions.

Because federal law and regulations make it virtually impossible for providers to structure pools of Medicaid and Medicaid receivables, these potentially huge sources of collateral for ABS transactions have been off-limits for a long time. And other changes in the healthcare financing environment have been making Healthcare receivables ABS less and less attractive as options for hospitals seeking to manage cash flow as efficiently as possible. For example, the growing acceptance by providers of standard consumer credit cards for payment of the patient portion of procedures effectively outsourced that segment of each hospital’s receivables and collection challenge to the credit card firms. The growth of charity care reimbursement programs such as those seen in New jersey, Michigan, Illinois, and other states, programs to smooth Medicaid payments to hospitals serving high percentages of low-income patients, and the development of the federal Disproportionate Share (DSH) system have all proven to be helpful alternatives to selling receivables in managing.

Nonetheless, some healthcare receivables ABS transactions have continued to be issued. For example, Healthcare Finance Group, Inc. successfully sold an HFG Healthco-4 LLC, series 2006-1 in June of 2006. This transaction is backed primarily by health care receivables that secure revolving lines of credit arranged by Healthcare Finance Group, Inc. and provided by the trust to health care providers lines of credit are essentially working capital asset-based loans secured by a provider's pledge of the receivables due from third-party payors such as Medicare, Medicaid, Blue Cross and Blue Shield Plans, commercial insurers, and managed health care organizations.

In very sharp contrast to the specialized and often very troubled healthcare receivables ABS sector, the credit card receivables ABS sector has been a staple of successful ABS issuance since their development and successful introduction in 1987. This structure is now used throughout the developed world and is being seen increasingly in the emerging markets, as well.

ABS backed by credit card receivables are issued out of trusts that have evolved over time from discrete trusts to various types of master trusts of which the most common is the de-linked master trust. Discrete trusts consist of a fixed or static pool of receivables that are tranched into senior/subordinated bonds. A master trust has the advantage of offering multiple deals out of the same trust as the number of receivables grows, each of which is entitled to a pro-rata share of all of the receivables. The de-linked structures allow the issuer to separate the senior and subordinate series within a trust and issue them at different points in time. The latter two structures allow investors to benefit from a larger pool of loans made over time rather than one static pool.

The consumer credit terms for users of credit cards whose managers are routinely using ABS transactions to access the capital markets range from relatively reasonable, e.g. below 10% APR to the downright confiscatory, e.g. as high as 30% or above.  Because investors in each tranche of credit card ABS are looking for risk-adjusted market returns, there may be ways to use philanthropic or other “compassionate capital” which is willing to accept below-market rates of return for the higher risk (lower-rated) tranches of credit card receivables-backed ABS transactions, significantly lowering their all-in cost of funds, and passing that benefit back through to the individual borrower. This concept could be applied to medical credit cards.

Speaks to multiple leverage points.

• Potential  of new alliances to create risk pooling or collective purchasing/action
• As entities explore ideas such as non-profit medical credit, they could find interesting new partners, e.g. those with compassionate credit to invest in equity or mezzanine tranches of medical credit card receivables transactions.

• Risk sharing at the micro level balanced against risk management at macro level
• Philanthropic and other forms of compassionate capital could drive a new paradigm for medical credit risk evaluation and risk transfer to both the compassionate capital markets and conventional capital markets, at the macro level