What Is an Asset-Backed Security (ABS)?
A type of financial investment that is guaranteed by an underlying pool of assets, especially those, which generate a cash flow from debt, like loans, leases, credit card balances, or receivables is termed as asset-backed security (ABS).
An ABS pays income at a fixed rate for a set period of time till maturity, by taking the form of a bond or note.
For income-oriented investors, compared to other debt instruments, like corporate bonds or bond funds the asset-backed securities can be a substitute.
Understanding Asset-Backed Securities (ABSs)
Issuers of Asset-backed securities are allowed to raise cash that can be used further for lending or other investment purposes.
The ABS assets are often illiquid and can’t be sold on their own.
So, when assets are pooled together to create a financial instrument out of them, then that process is called securitization.
This securitization allows the issuer to make illiquid assets marketable to investors, and also allows them to get unstable assets off their books, thus reducing their credit risk.
The expected cash flows like home equity loans, automobile loans, credit card receivables, student loans, or others are the underlying assets of these pools.
The asset-backed securities have been built with cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics so the issuers can be as creative as they want.
So any cash-producing vehicle or situation can be securitized into an ABS.
For investors, buying an ABS opens up the opportunity of a revenue stream.
The investors can participate in a wide variety of income-generating assets which is allowed to them by ABS, which is not available in any other investment.
How does the Asset-Backed Security Work?
If a particular Company is into making automobile loans and if an individual wants to borrow money to buy a car, then this company can give cash to that person, which the person repays with a certain amount of interest.
If the Company has so many loans that it runs out of cash then it can package its current loans and sell them to other Investment Firms and receive the cash, to use for making further loans.
Now the Investment Firm will categorize the purchased loans into different groups called tranches.
Which are loans with similar characteristics, like maturity, interest rate, and expected delinquency rate.
The Investment Firm will then issue securities on each tranche created.
Depending on its degree of riskiness, which is, the probability of the underlying loans to go into default each ABS has a rating that is similar to bonds.
These securities are then purchased by the individual investors who receive the cash flows from the underlying pool of auto loans, after deducting the administration fees which the Investment Firm keeps for itself.
Special Considerations
There are three tranches in asset-based security, which are: class A, B, and C. The largest tranche of a senior tranche — A, is designed to have an investment-grade rating to make it attractive to investors.
The credit quality is lower in the B tranche and, here it has a higher yield than the senior tranche.
Likewise, the C tranche has a lower credit rating than the B tranche and has poorer credit quality so it can’t be sold to investors.
So the C tranche would be kept by the issuer and soak up the losses.
Types of Asset-Backed Securities
Right from mobile home loans to utility bills anything that generates an income stream can create asset-based security (ABS). But the most common ABS are:
Collateralized Debt Obligation (CDO)
A CDO is an asset-backed security that is issued by a special purpose vehicle (SPV).
The business entity or trust which is set up particularly to issues that ABS is called SPV. The CDO has various subsets including:
- Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
- Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
- Structured finance-backed CDOs having underlying assets of ABS, including residential or commercial mortgages, or real estate investment trust (REIT) debt.
- Cash CDOs are backed by cash-market debt instruments, where the other credit derivatives support synthetic CDOs.
- Collateralized mortgage obligations (CMOs) which compose of mortgages specifically mortgage-backed securities, which hold portfolios of mortgages.
Though a CDO and ABS have the same structure some consider the CDO as a separate type of investment vehicle.
The CDOs own a broader and more assorted range of assets, which could include other asset-based securities or CDOs.
Home Equity Loan ABS
One of the largest categories of ABS is home equity loans.
Though it is the same as mortgages, home equity loans are taken out by borrowers who do not have very good credit scores or few assets because of which they didn’t qualify for a mortgage.
They are amortizing loans, and the payment consists of three categories: interest, principal, and prepayments.
Auto Loan ABS
Another large category of ABS is car financing this is an amortizing loan.
The monthly interest payments, principal payments, and prepayments for an auto loan ABS are much lower when compared to a home equity loan ABS.
Credit Card Receivables ABS
Credit card receivables are the amount due on credit card balances, which is a type of non-amortizing asset ABS. Instead of towards the same set sum, they go to a revolving line of credit.
Hence they don’t have fixed payment amounts, but new loans and changes can be added to the composition of the pool.
Interest, principal payments, and annual fees are the cash flows of credit card receivables.
Credit card receivables do not have payment of principal and if the principal is paid within the lock-up period, the new loans will be added to the ABS with the principal payment making the pool of credit card receivables remain unchanged.
After the lock-up period, the ABS investor receives the principal payment.
Student Loan ABS
ABSs can be collateralized by both the government student loans that are guaranteed by the U.S. Dept. of Education and private student loans.
The government student loan has had a better repayment record and a lower risk of default.
Conclusion
The income-generating assets like credit card receivables, home equity loans, student loans, and auto loans that back the financial securities are called Asset-backed securities (ABSs).
When a company sells its loans or other debts to an issuer, or when a financial institution then packages them into a portfolio to sell to investors then an ABS gets created.
When assets are merged into an ABS then the process is called securitization.
Because the income-oriented investors, pay a steady stream of interest, like bonds ABSs appeal to them.
The mortgage-backed securities and collateralized debt obligations are the types of ABS.
https://www.compareclosing.com/blog/all-about-asset-backed-securities-abs/
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