Definition
Asset-Backed Securities (ABS) are financial investment instruments that are backed by specific collateral or pool of assets, such as mortgages, loans, and credit-card debt. These are created when these assets are bundled together and then securitized, creating an income-generating product for the investor. ABS allow the issuing companies to raise funds from these otherwise illiquid assets.
Key Takeaways
- Asset-Backed Securities (ABS) are investments that are collateralized by a pool of assets. These could include loans, leases, credit card debt, a company’s receivables, royalties and so on, that generate receivables over a period of time.
- ABS allows financial institutions to improve liquidity since it basically converts illiquid assets into tradable commodities. This practice can potentially ease the lending process as it lowers the risk for financial institutions.
- However, ABS may also carry considerable risks as they’re often complex and it can be difficult to accurately assess their value. This is especially true if the underlying assets become non-performing as in the case of the 2008 financial crisis with mortgage-backed securities.
Importance
Asset Backed Securities (ABS) are a significant part of the financial system due to their role in promoting liquidity, risk dispersion, and capital efficiency.
By transforming illiquid assets into tradable securities, they allow institutions like banks to free up their balance sheets, providing them with more capital to extend additional loans and stimulate economic activity.
This increased liquidity can also lead to lower borrowing costs.
Moreover, by pooling diverse assets together and dividing the risk between different investors, ABS can distribute risk more optimally – a fundamental aspect of financial stability.
Therefore, ABS are crucial to a functioning and efficient financial system.
Explanation
Asset-Backed Securities (ABS) are financial instruments primarily used to diversify large pools of risk. These securities allow institutions and individuals to invest in diverse portfolios of income-generating assets—these could include loans, leases, credit card debt, a company’s receivables, fleet leases, royalties and so forth.
By bundling and securitizing these assets, financial institutions can transfer the risk associated with these assets to investors. In return, these investors get exposure to unique asset classes that typically offer attractive yields, and are shielded from the direct risk of default.
The main purpose of ABS is to redistribute the risk associated with the underlying assets to different investors with varying risk appetites. Additionally, ABS also provide liquidity to industries that provide the securitized assets, since they can bring to market financial products that would typically be considered too risky to invest in on an individual basis.
For banks and financial institutions, it becomes an effective way to remove risky assets from their balance sheets. For investors, these securities offer an opportunity to invest in a diversified and often high-yield set of assets.
Examples of Asset Backed Securities
Mortgage-Backed Securities (MBS): One of the most common examples of asset-backed securities are mortgage-backed securities. These are a type of investment that is backed by mortgages. Banks and other financial institutions often sell the loans they have issued to homebuyers to investment firms. These firms package multiple mortgages together into a mortgage-backed security that investors can then purchase. The investors receive income from the mortgage payments.
Auto Loan ABS: Another standard real-world example is an auto loan asset-backed security. This type of ABS is backed by the car loans that finance companies bundle for selling to large investors. Investors make a return from the car loan repayments paid by the customers who borrowed money to buy their vehicles.
Credit Card Receivables ABS: This type of asset-backed security is supported by the accumulated credit card debt of several consumers. When the individuals pay off their credit card bills, the investors who have invested in the credit card receivables ABS make a return.
FAQs on Asset Backed Securities
What are Asset Backed Securities?
Asset Backed Securities (ABS) are financial products that are based on pools of assets, or collateralized by these assets. These assets are then sold to a special purpose vehicle (SPV) or entity (SPE) which then issues securities that can be purchased by investors.
What types of assets are usually involved?
Several types of assets could be involved such as auto loans, home equity loans, student loans, credit card receivables, and more. Essentially, any debt which generates a payment stream can be securitized into ABS.
Why would investors be interested in ABS?
Asset backed securities can be attractive investments because they generally offer a higher yield compared with other securities. The risk involved is also diversified due to the large pool of underlying assets.
Are there risks involved with investing in ABS?
Yes, investing in asset backed securities comes with risks. Some risks include credit risk, liquidity risk, and interest rate risk. Investors must do a careful risk analysis before purchasing these types of securities.
What impact did ABS have on the financial crisis in 2008?
The financial crisis of 2008 saw a massive default in asset-backed securities associated with U.S. home mortgages. These securities had been widely purchased and held by financial institutions around the globe. The failure of these securities resulted in a worldwide economic recession.
Related Entrepreneurship Terms
- Collateralized Debt Obligations (CDOs)
- Mortgage-Backed Securities (MBS)
- Securitization
- Tranches
- Credit Rating Agencies
Sources for More Information
- Investopedia: This website offers a wealth of information about financial terms and concepts like Asset Backed Securities.
- Corporate Finance Institute: This organization provides online training and certification programs while providing a treasury of knowledge about various finance-related topics.
- The Motley Fool: This company offers advice about stocks and investments, including complex topics like Asset Backed Securities.
- WallStreetMojo: This website offers comprehensive articles about a range of finance and investment terms, including Asset Backed Securities.
