Asset-Backed Security: What Is It and How Does It Work?

For investment instruments, asset backing means a security instrument whose value derives from a pool of assets. These assets are used as collateral or backing for the newly created security. Thus, asset-backed security (ABS) refers to a security that is backed by a pool of financial assets such as different types of loans.

Asset-backed securities provide a flexible investment opportunity for banks and financial institutions. It is also a good way of mitigating risk due to unsafe assets. The default and credit risk shifts from the financial institution to the investors with Asset-backed Securities.

What is an Asset-Backed Security?

Asset-backed securities are derived from and collateralized by a pool of financial assets. These assets are pooled together to form new financial security. Financial institutions usually create ABS out of financial assets that generate cash flows such as different types of loans, mortgages, etc.

The asset-backed security then takes the form of a bond or note that becomes marketable security. Investors can buy these securities for discounted prices and returns through coupon payments. In addition, cash flows from the underlying assets of the ABS are passed through to the investors. It means the risks associated with the underlying assets are also passed on to the investors.

How Does an Asset-Backed Security Work?

Financial institutions, for instance, banks and credit unions, offer loans to retail consumers. These loans can be backed by collateral or unsafe loans without any pledge. Borrower’s liabilities towards lenders become assets on their balance sheets.

Lenders can face liquidity issues with a large number of loans. One way of arranging cash for these institutes is to pool loans and sell them as security. It is called securitization of debt products. These loans would otherwise have no value to investors if sold individually.

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The pooling of assets adds value to the newly created security. It then becomes marketable security and offers lucrative returns to investors.

Types of Asset-Backed Securities

Securitization of debt instruments can be classified into different categories called tranches. There are usually three tranches of ABS securities, A, B, and C.

Category A comprises the highest rating loans. These loans are often backed by a pledged collateral. Category B loans usually come with lower ratings but are still considered worth investments. Whereas, category C loans are often unsafe loans without a pledge or collateral. Financial institutions do not offer category C loans as marketable securities nowadays.

Asset-Backed securities can also be categorized based on the types of debt. Most commonly used debt instruments for ABS include:

  • Collateralized Debt Obligations – CDOs
    • Collateralized Loan Obligations (CLOs) – Bank Loans
    • Collateralized Bond Obligations (CBOs) – Bonds
    • Collateralized Mortgage Obligations (CMOs) – Mortgages
  • Home Equity Loan ABS
  • Auto Loan ABS
  • Student Loan ABS
  • Credit Card Loan ABS

Important Considerations with Asset-Backed Securities

Asset-Backed Securities comprise a large number of loans. These securities often include different classes of debt obligations. Some of these loans would be with collateral and positive ratings. Others would come with low credit ratings and higher default risks.

Investors cannot evaluate the true credit ratings of these underlying assets of an ABS. Thus, these investments can be risky ventures for retail investors. If a particular ABS comprises of a specific loan type, it would carry economic and market risks as well.

For instance, as we had seen in the global financial crunch of 2008. Sub-prime mortgages were bundled into asset-backed securities. In an economic recession, lenders started to default. As the sub-prime mortgages were not backed by assets and these assets lost market value quickly, it created a financial slump.

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Another risk factor with ABS is that it may affect a number of corporate and retail investors at the same time. If original borrowers of these loans default in the majority, all investors and sellers of the ABS would get affected. Nowadays, financial institutes include a small proportion of a particular loan segment when creating asset-backed security for these reasons.

Advantage of Asset-Backed Securities

Asset-backed securities offer some good benefits to corporate and retail investors.

  • Lending institutes can remove risky loans from their balance sheets through securitization.
  • ABS provides a new source of funding for financial institutes.
  • These securities offer higher yields and return to investors as compared to more conservative investments such as government bonds.
  • Lenders can shift the default and credit risk of original borrowers to the new investors.

Disadvantages of Asset-Backed Securities

Asset-backed securities often some risks and disadvantages as well.

  • Particular low rating assets in an ABS can cause a widespread economic downturn as we have seen in the past.
  • Investors cannot evaluate the creditworthiness of the underlying assets in an ABS.
  • Investors’ yield may decrease in a certain segment of ABS if the original borrowers make large prepayments.

Final Thoughts

Asset-backed securities provide an alternative source of funding for lending institutes. These securities are created by pooling a large number of debt instruments into a new marketable security. Therefore, investors must carefully evaluate the tranches or ratings of these securities to mitigate any risks.

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