Asset-Backed Securities Explained for Dummies

What is asset-backed security (ABS)?

An asset-backed security is a type of financial security created by bundling underlying assets, such as leases, student loans, auto loans, and credit card debt, together in a process called securitization.  

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What is securitization?

Securitization refers to a process in which an issuer of securities creates marketable securities by bundling or pooling various financial assets together, especially loans and other forms of debt, aiming to generate cash by selling them to investors. Securitization advances liquidity in the marketplace by providing opportunities for investors and capital for issuers of securities. Express differently, securitization transforms illiquid underlying assets (loans and other forms of debt) into liquid assets that are marketable to investors. Marketable securities that are created through securitization are also referred to as securitized debt instruments, of which the following two types are the most common ones:

• Mortgage-backed securities (MBSs) are secured by mortgages for real estate properties such as homes.

• Asset-backed securities (ABSs) are secured by financial assets, generally, those that generate cash flows from debt, such as loans, leases, and receivables.

 

Details of asset-backed securities (ABSs)

Debt, such as loans provided by lenders to borrowers, is reported as an asset on the balance sheet of a lender because they provide the lender with principal payments and interest. Most of the loans provided to individuals are student loans, auto (vehicle) loans, or credit card debt. These types of debt are usually small and cannot be sold to investors individually. Hence, a lender such as a bank or a vehicle financing company joins its current loans together and sells them to a securities issuer, such as an investment firm or securities business. The securities issuer will then put the purchased loans into different categories, referred to as tranches or slices. The loans are categorised and rated according to their similar features, such as interest rate, maturity, and expected delinquency rate, which is an indication of the percentage of loans that are past due. The rating of each ABS refers to the extent of its investment risk, indicating how likely the underlying loans will go into default. An ABS will normally be classified in terms of one of three trenches: class A, class B, and class C.

• The A tranche is the largest tranche and has a credit rating designed to make it attractive for investors.
• The B tranche has a lower credit rating than the A tranche, however with a higher yield.
• The C tranche has a lower credit rating than the B tranche, with such a poor credit quality that it cannot be sold to investors. In this situation, the securities issuer would keep the tranche and bear the losses.

The result is that each ABS contains only a portion of the risk of the total bundle of underlying assets. Securities issuers offer the ABSs to investors. With the purchase of an ABS, an investor receives the cash flows (the interest and principal payments) from the underlying loans, as well as the risk pertaining to the particular ABS. The securities issuer usually deducts an administrative fee.  

Types of assets used to create asset-backed securities

The following are examples of assets sold by lenders, such as banks, vehicle financing companies, and other financial institutions, to securities issuers. Remember, a loan is a liability for a borrower but an asset for the lender.  

Home equity loans

Home equity loans are one of the largest types of ABSs. They allow homeowners to borrow against the non-mortgaged value of their homes. Home equity loans are typically obtained by borrowers who have unsatisfactory credit ratings or few assets. Hence, they do not qualify for a mortgage. They are amortising (also spelled amortizing) loans, meaning a borrower is obliged to repay a loan in instalments, usually monthly, comprising a portion of the principal amount and interest.  

Auto loans

Auto financing is also a large category of asset-backed securities. An auto loan, also known as a car loan or a vehicle loan, is also an amortising loan. However, the amount of a monthly instalment is much lower compared to a home equity loan.  

Credit card receivables

Credit card receivables refer to the amount due on credit card balances. They are one of the oldest sections of the ABS market. They are a type of non-amortising loan, meaning they do not have fixed monthly instalments and credit cardholders are not required to pay off the principal on a schedule. Instead, holders of credit cards are allowed to pay a small required minimum amount on a regular basis, usually once a month.  

Student loans

ABSs that use student loans as underlying assets, can be collateralized by either private student loans or student loans guaranteed by a government. Student loans backed by a government are less susceptible to default risk, while lenders of private student loans bear more default risk. Student loans are also amortising assets, required to be paid off according to a specified schedule.  

Pros of asset-backed securities

• Removing potentially risky loans

A benefit for issuers of ABSs is that potentially risky loans are removed from their balance sheet. In addition, a source of new funds is generated, allowing issuers to pursue new business opportunities.

• Expanding portfolio diversification

Concerning investors (buyers), asset-backed securities provide an alternative type of investment that provides higher yields and more stability than government bonds. In addition, ABSs enable investors to expand their portfolio diversification.

• Minimising default and credit risks

Each ABS contains only a portion of all the underlying assets, minimising default risk and other credit risks.  

Cons of asset-backed securities

• Prepayment risks

Prepayment risks occur when the borrowers of the underlying loans settle their loans before the final date of the loans. This can cause a lower yield for investors who hold the ABS.

• Risks pertaining to underlying assets in arrears

As mentioned, default risk is spread across a wide range of underlying assets. However, if the assets are of a low credit rating, an ABS could be subjected to widespread defaults during an economic recession.   This article does not intend to provide investment or trading advice. Its aim is only informative.    

Frequently Asked Questions

   

What is asset-backed securities?

  ABS (asset-backed securities) are those securities that are derived from a pool of underlying assets.  

Is it good to invest in Asset-backed securities?

  Investing in ABS generally lead to higher yields and greater stability than government bonds. Asset backed securities provide investors with portfolio diversification, which is a bonus for those looking to invest in other markets.  

What are the types of assets that are used to create Asset-backed securities?

  Examples of assets sold by lenders (eg. Banks) incl:  Home equity loans, Auto loans, Credit card receivables, Student loans.  

What are the benefits of Asset-backed Securities?

  It can protect a lender from a potentially risky loan. It provides investors with an alternative and overall more stable investment vehicle. ABS serves to reduce default risk and other credit risks.  

What are the risks involved in Asset-backed Securities?

  A lack of due diligence to evaluate all the underlying assets may expose retailers to unforeseen risks.  ASB may be subject to prepayment risks. Low quality underlying assets mean that security can suffer from widespread defaults in the case of an economic downturn.  

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