The term asset-backed security, or ABS, is used to describe a variety of securities that rely on a collection of assets as collateral, and provide a cash flow back to lenders. The most common pools of assets include home equity and automobile loans, credit card receivables, student loans, and even leases.
In this article, we're going to talk about a special class of investments: asset-backed securities. We'll start by providing a definition of the term; describe how these investments are typically structured, and how they're traded. Next, we'll describe the most common types of securities offered on the market. Then we'll finish up with the pros and cons associated with investing in an asset-backed security.
As the name implies, an asset-backed security is a class of investments whose cash flow is backed by a pool of assets. Generally, asset-backed securities are created by lenders that wish to convert balance sheet assets, such as receivables or loans, into a tradable security. The process of removing these assets from the balance sheet makes additional capital available to the lender, enabling them to write more loans.
Regardless if the assets are loans, or mortgages, the steps in creating an ABS is similar:
To summarize, the above process might go something like this: Lenders reach a point where they need to clean up their balance sheets so they can write additional loans. They sell their collateralized loans to a large financial institution, which creates a special purpose vehicle, or trust, and these loans are placed into that trust. Cash flows into this trust as payments on the loans are made, and cash flows out as payments are made to the investors that purchased the securities issued by the trust.
When the special purpose vehicle is created by a financial institution, it is sometimes referred to as a bankruptcy remote trust. Depending on the quality of the assets, the SPV can have a higher (better) overall credit rating than the financial institution that created it.
Furthermore, the trust will typically subdivide the pool of securities into what are called tranches. Each tranche carries a different combination of risk and reward and might include:
The trading of asset-backed securities takes place on various exchanges, and is similar to the process of trading corporate bonds. Public offerings need to satisfy the U.S. Securities and Exchange Commission requirements. This will include financial disclosures to investors. These securities are often assigned ratings from credit agencies based on the quality of the underlying cash flow.
Interest payments can be passed directly through to investors after administrative fees are subtracted. This arrangement is referred to as a "pass-through" security. With "structured" securities, payments to investors are distributed according to predetermined rules.
The most common types of collateral used for asset-backed securities appear below:
Collateralized Bond Obligations, or CBOs, are another type of asset-backed security. These investments warrant an entirely separate topic, and have been covered in our article: collateralized bond obligations.
Asset-backed securities provide lenders with the ability to trade a collection of assets that could not be sold individually. Turning these illiquid assets into cash, lenders are then free to write additional loans. By creating tranches of securities from this pool of assets, investors are able to select a risk / reward offering that aligns with their risk tolerance. Finally, asset-backed securities pay investors a yield premium when compared to more traditional offerings carrying the same credit ratings.
While all securities carry certain risks, such as interest rate and market liquidity, there are three significant risks investors assume when they purchase ABS:
All of the above result in the unscheduled shrinking of the assets held in the trust, or the premature return of a portion of the investor's money. In the case of bankruptcy, not only is the cash flow into the trust lost, but the eventual repayment of the investors' money is uncertain.
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