Asset-Backed Securities

What are Asset-Backed Securities (ABS)?

Definition: Asset-backed securities (ABS) are securities, usually bonds, which are collateralized by financial assets, such as home equity lines, credit card receivables, and auto loans.

What Does Asset Backed Securities Mean?

When consumers borrow money – whether by taking out a home-equity or auto loan, or by running a balance on a credit card – their loans become assets on the books of the entity that extended the credit – a bank, an auto finance company or a consumer finance company.

The assets may be sold to a trust – a corporation that exists only on paper, and whose sole purpose is to issue bonds backed by the assets it contains – asset-backed securities. If, for example, your car loan has been “securitized,” your payments on the loan flow through the trust to the investors in the asset-backed securities issued by the trust.

The main types of asset-backed securities are home-equity loans, credit-card receivables, auto loans, mobile home loans and student loans. Asset-backed securities are purchased primarily by institutional investors, including corporate bond mutual funds. They are a variety of spread product and are evaluated as such.

Financial institutions that originate loans — including banks, credit card providers, auto finance companies and consumer finance companies — turn their loans into marketable securities through a process known as securitization. The loan originators are commonly referred to as the issuers of ABS, but in fact they are the sponsors, not the direct issuers, of these securities.

These financial institutions sell pools of loans to a special-purpose vehicle (SPV), whose sole function is to buy such assets in order to securitize them. The SPV, which is usually a corporation, then sells them to a trust. The trust repackages the loans as interest-bearing securities and actually issues them. The “true sale” of the loans by the sponsor to the SPV provides “bankruptcy remoteness,” insulating the trust from the sponsor. The securities, which are sold to investors by the investment banks that underwrite them, are “credit-enhanced” with one or more forms of extra protection — whether internal, external or both.

Example

Company A is an auto finance company that offers car loans to consumers seeking to buy a new car. The company gives cash to the borrower, and the borrower agrees to repay the loan amount with interest.

The manager came up with a new way to increase the number of loans that the company gives out every month. He has read several articles on asset backed securities, and he decided that the company should capitalize on the opportunity to issue additional debts.

Company A sells its debt to an investment firm and receives the corresponding amount of cash, which allows the company to issue new debt and transfer them to the investment firm’s balance sheet. In the majority, the new automobile loans have the same maturity and inherent risk; therefore, the investment firm can issue a bond that forwards the proceeds of the auto loans to its investors.

The investment firm can trade its ABS, i.e. the bonds used as collateral for the vehicle loans, on various exchanges provided that they meet the securitization requirements.

ABS Benefits

The benefit for the issuer of an ABS is that the issuer removes these items from its balance sheet, thereby gaining both a source of new funds as well as greater flexibility to pursue new business. The benefit to the buyer — usually institutional investors — is that they can pick up additional yield relative to government bonds and augment their portfolio diversification.

ABS Risks

While some investors have success with ABS investments, some ABS have historically turned out to be bad investments. It was the meltdown of ABS holding sub-prime mortgages that initiated the Great Recession that began in late 2007.

Only financially sophisticated, wealthy investors should buy individual asset-backed securities directly. Evaluating the underlying loans requires considerable research and the process of acquiring the necessary data isn’t always straightforward.

ABS carry some prepayment risk, which is the chance that investors will experience reduced cash flows caused by borrowers paying off their loans early, particularly in a low-yield environment when borrowers can refinance existing loans at lower rates.

The mixed history of ABS securities suggests that some caution needs to be exercised, even when buying AAA or AA rated ABS. In the past, the credit ratings attached to ABS by Moody’s and other rating agencies have not always been reliable.

Summary

Define Asset-Backed Security: ABS means a financial instrument that is guaranteed against default with an asset.

  • Asset-backed securities (ABS) are financial securities backed by assets such as credit card receivables, home-equity loans and auto loans.
  • Although they are similar to mortgage-backed securities, asset-backed securities are not collaterized by mortgage-based assets.
  • ABS appeal to investors looking to invest in something other than corporate debt.