Asset backed securities are complex investments that are backed by an underlying financial asset. These financial assets are a group of illiquid assets which are unable to be sold individually. Common asset backed securities include credit card loans, student loans, auto loans, home equity loans, etc. Mortgage loans are excluded and are not considered asset backed securities as they can be packaged and sold as a “mortgage-backed security.”
Formation of Asset Backed Securities
Asset backed securities or ABS are considered fixed income instruments that are backed by underlying financial assets such as:
- Credit Card Loans,
- Home Equity Loans
- Auto Loans
- Student Loans
Asset backed securities differ in comparison to bonds as their creditworthiness depends on the paying ability of the originator of the loan and not on the issuer itself.
Securitization Process
Through the process of securitization, institutions such as banks, credit card providers, auto and consumer finance companies pool the outstanding loans into one group for the purpose of turning them into a marketable security. These pool of securities are sold to a special purpose vehicle (SPV) often a corporation, whose goal is to buy the assets and continue the securitization process. The corporation would in turn sell the loans to a trust company who re-packages them as interest bearing securities and issues them to the general market.
Benefits to the Institutions
- New Capital – Institutions are able to raise capital at rates that would be considered more affordable than if they were to go through a commercial bank. Rates may be fixed or variable, aligned to the prime rate.
- Clean Balance Sheet – By pooling loans, institutions are able to clean their balance sheet by freeing up cash sitting idle and remove the risk of debt.
- Enhanced Liquidity – By removing the risk of debt and turning it liquid, the institutions are still able to earn income by lending the capital back out to new borrowers or interested investors.
Benefits to the Investor
- Choice for the Investor – Asset backed securities allow the investor to choose exposure to specific sectors in the economy. In addition to home equity loan payments, an investor can choose to purchase ABS that are related to proceeds from car loans, equipment leases, student loans, etc.
- No Intermediary Risk – An investor would not have to worry about the risk profile that the institution has bundled up together in an asset backed security. Even if the institution were to go into default, the income stream would be unaffected thus not exposing you to the risk profile of an intermediary.
- Higher Yields – Asset backed securities tend to offer higher yields than comparable T-bills or yields that are similar to corporate bonds and mortgage backed securities.
Mortgage Backed Securities
Mortgage loans are excluded in the securitization process and are not considered asset backed securities as they can be packaged and sold as a “mortgage-backed security.” Mortgage backed securities have long been blamed for the 2008 Financial Crisis, also known as the subprime mortgage crisis. Large pools of mortgages were packaged together and sold to various institutional, corporate and individual investors. The housing bubble caused a large decline in home prices which in turn led to mortgage delinquencies, foreclosures and devaluation of housing related projects.
When a corporation purchases a MBS, they have the right to receive the monthly mortgage payments that come with it. The value of the MBS is based on the quality of the underlying asset. During the collapse of 2008, many banks were issuing low quality mortgages which led to higher rate of defaults.