What is an Asset-backed Security? Types and How Does It Work

Asset-backed securities are those financial instruments that derive their value from one asset or a pool of assets held by the issuer.

Usually, we refer to bonds or notes comprising different types of debt and loan instruments repackaged and sold in the market to investors.

Let us discuss asset-backed security, how it works, and its different types.

What is an Asset-Backed Security?

An asset-backed security is a type of investment issued by a special-purpose entity using pooled assets through a process known as securitization.

Asset-backed securities are normally issued against different types of loans issued by a financial institute. A new entity is created to securitize these loans into a pooled set of assets and sold to investors.

Assets owned by the issuer institute back the securities issued through this process. Loans and mortgages are assets of banks and private lenders.

Commonly used assets for these securities include home mortgages, home equity loans, auto loans, student loans, and credit card loans.

An asset-backed security is issued in the form of a bond or note. They work as a fixed-income instrument for investors with a set maturity period, interest rate, and payment plan.

How Do Asset-Backed Securities (ABS) Work?

Asset-backed securities comprise small assets owned by a financial institute like a commercial bank. These assets are usually loan products offered to corporate and retail borrowers.

Financial institutions repackage these assets and create a new pool of investment. These assets are then managed by a new special purpose entity (SPE) or special purpose vehicle (SPV).

The SPE then passes on the interest and principal repayments received from original borrowers to new investors of ABS.

Since Asset-backed securities come with defined cash flows, they attract investors looking for fixed-income instruments.

Some customized ABS types are designed for corporate investors like pension or hedge funds and others for any investor.

The issuers of ABS pass on the income stream to investors keeping a margin for themselves (through SPE) and also shifting the risks.

However, the risks are often diversified for investors as an ABS contains different types of assets.

What is Securitization?

Securitization refers to the process of pooling or grouping several financial assets into a new marketable security.

Securitization is arranged for assets with consistent cash flows. Loans, credit card debts, and mortgages are common examples of such assets.

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This process allows the owner of these assets to remove risky assets from the balance sheet. They transfer the risks linked to these assets to new investors.

Without securitization, individual assets like mortgages or loans are difficult to sell. When these assets are pooled, they can attract investors.

Asset-backed securities created through securitization are then classified into different categories called trenches.

An ABS comprising assets of the highest class and lower risk is classified as category A. However, it offers a low return to investors due to the low risk of investment.

Similarly, other ABS are classified as B and C. The classification is done by arranging the risk profile of the assets, the credit rating of the issuer, and the quality of the cash flow streams.

Types of Asset-Backed Securities

Asset-backed securities can be created for several types of financial assets. A financial institute can securitize financial assets and offer them to investors in the form of a bond or note.

Typically, ABS are classified into different categories based on the type of financial asset they hold.

Collateralized Debt Obligation – CDO

A CDO is a special type of ABS comprising different types of debt obligations. A CDO is arranged and managed through a special purpose vehicle (SPV).

The SPV arranges a wide pool of debt obligation assets into a single security.

A CDO typically includes:

  • Collateralized loan obligations (CLOs) with commercial bank loans.
  • Collateralized bond obligations (CBOs) comprise bonds.
  • Cash CDOs comprise cash-market instruments.
  • Collateralized mortgage obligations (CMOs) comprise mortgage loans.

Although many experts categorized CMO as a separate type of ABS.

Home Equity Loan ABS

This type of ABS comprises home equity loans. Home equity loans are often issued to borrowers with lower credit scores than those mortgage borrowers.

In that sense, home equity ABS would be riskier than CMOs. Hence, investors would expect higher returns as well.

Cash flows from these securities are interest payments, principal payments, and loan prepayments.

Credit Card Receivable ABS

Pooling receivables from credit card loans create this type of asset-backed security. This is a non-amortizing loan type security as credit card loans are lines of credit or a form of revolving credit.

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This is why new loans are constantly added to ABS’s credit card. Investors receive returns through interest payments, principal repayments, and early payments.

Auto Loan and Student Loan ABS

Pooling auto loans and student loans create these types of asset-backed securities. They are created, managed, and marketed separately by the issuers.

Auto loan ABS comprises car financing by banks and other lenders. The cash flows include interest payments, principal repayment, and down payments.

Student loan ABS comprises government student loans largely.

Other Forms of ABS

Asset-backed securities are conventionally created out of commercial loans, mortgages, and other types of debt instruments.

However, more financial institutes are creating asset-backed securities comprising cash flows from airport slots, road tolls, cell towers, royalty revenue streams, etc.

These types of ABS create further diversification of risks and offer a unique opportunity for the sellers as well.

Asset-Backed Securities v Mortgage-Backed Securities

Asset-backed securities (ABS) and mortgage-based securities (MBS) are often used interchangeably. Some consider them similar instruments and others categorize them separately.

Mortgage-based security comprises only real-estate loans (mortgages). It is a pooled set of mortgage loans into single market security.

An MBS is also offered through an SPE or SPV. It generates fixed income for investors through interest payments, principal repayment, and loan down payments.

On the other hand, an ABS may include mortgage loans but can have a wide range of other types of debt instruments like auto loans, credit card loans, student loans, and home equity loans.

We can say mortgage-backed securities are subsets of asset-backed securities as ABS can include a wider range of cash-generating instruments other than mortgages.

Impact of Securitization on Economy and Financial Markets

The securitization of financial instruments offers several benefits to issuers and investors alike.

Financial institutions like commercial banks can diversify their risk exposures through securitization.

They can generate income from illiquid assets otherwise unable to generate anything substantial.

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Then, banks and other institutes can use income generated through asset-backed securities to offer more services to individuals and businesses. Therefore, this process increases market liquidity.

On the other hand, investors find a better way to invest in securities that would be otherwise inaccessible to them.

Investors cannot invest in products like mortgages or commercial loans without asset-backed securities.

ABS are issued in the form of bonds and notes which are tradable securities. However, ABS bonds are cheaper to issue than corporate bonds.

Asset-backed securities come with inherent credit risks. Banks and other issuers may repackage risky assets (unsecured loans or subprime mortgages) into new marketable securities.

As we’ve seen in the global financial crisis, exposure to ABS risks can be catastrophic for the economy and financial markets.

Advantages of Asset-Backed Securities

Asset-backed securities offer several advantages to issuers like banks, financial institutes, and investors.

  • Asset-backed securities reduce issuers’ financial risks by removing risky loans and debt instruments from their balance sheets.
  • ABS are issued through SPVs which can help improve the credit rating for bonds issued as compared to the issuer’s credit rating.
  • ABS bond trenches diversify and spread credit and prepayment risks linked to different types of debt instruments held by the issuer.
  • Issuers receive greater liquidity through securitization which would otherwise be impossible.
  • Investors can invest in alternative and relatively stable instruments as compared to individual debt instruments.
  • Without securitization, investors would not be able to invest in debt and loan securities.

Disadvantages of Asset-Backed Securities

Asset-backed securities come with some disadvantages as well.

  • ABS can comprise risky and unsecured debt instruments like subprime mortgages which resulted in the global financial crisis in the past.
  • Investors may not be able to evaluate the credit and default risks of securities included in an ABS.
  • ABS is not totally free from prepayment and credit risks.
  • Investors may receive potentially lower yields if the borrowers start repaying their debts early.
  • Finally, unsecured debts and subprime mortgage loans may result in widespread economic crisis as the default risk is distributed among several stakeholders.