how an asset backed security works
assume that company x is in the business of making automobile loans if a person wants to borrow money to buy a car company x gives that person the cash and the person is obligated to repay the loan with a certain amount of interest perhaps company x makes so many loans that it starts to run out of cash company x can then package its current loans and sell them to investment firm x thus receiving the cash which it can then use to make more loans investment firm x will then sort the purchased loans into different groups called tranches these tranches contain loans with similar characteristics such as maturity interest rate and expected delinquency rate next investment firm x will issue securities based on each tranche it creates similar to bonds each abs has a rating indicating its degree of riskiness that is the likelihood that the underlying loans will go into default 3individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans minus an administrative fee that investment firm x keeps for itself an abs will usually have three tranch classes a b and c the senior tranche a is almost always the largest tranche and is structured to have an investment grade rating to make it attractive to investors the b tranche has lower credit quality and thus has a higher yield than the senior tranche 3 the c tranche has a lower credit rating than the b tranche and might have such poor credit quality that it can t be sold to investors in this case the issuer would keep the c tranche and absorb the losses types of asset backed securitiestheoretically an asset based security can be created out of almost anything that generates an income stream from mobile home loans to utility bills but certain types are more common among the most typical abs types are a cdo is an abs issued by a special purpose vehicle spv the spv is a business entity or trust formed specifically to issue that abs there are a variety of subsets of cdos including 45though a cdo is essentially structured the same as an abs some consider it a separate type of investment vehicle in general cdos own a wider and more diverse range of assets including other asset based securities or cdos 6home equity loans are one of the largest abs categories though similar to mortgages home equity loans are often taken out by borrowers who have less than stellar credit scores or few assets the reason why they didn t qualify for a mortgage these are amortizing loans that is payment goes toward satisfying a specific sum and consists of three categories interest principal and prepayments a mortgage backed security mbs is sometimes considered a type of abs but is more often classified as a separate variety of investment especially in the united states both operate in essentially the same way the difference lies in the underlying assets in the portfolio mortgage backed securities are formed by pooling together mortgages exclusively while asset backed securities consist of any other type of loan or debt instrument including rather confusingly home equity loans 2 mbss actually predate abss 7car financing is another large category of abs the cash flows of an auto loan abs include monthly interest payments principal payments and prepayments though the last is rarer for an auto loan abs is much lower than a home equity loan abs this is another amortizing loan 8credit card receivables the amount due on credit card balances are a type of non amortizing abs they go to a revolving line of credit rather than toward the same set sum thus they don t have fixed payment amounts while new loans and changes can be added to the composition of the pool the cash flows of credit card receivables include interest principal payments and annual fees there is usually a lockup period for credit card receivables where no principal will be paid if the principal is paid within the lockup period then new loans will be added to the abs with the principal payment that makes the pool of credit card receivables staying unchanged after the lockup period the principal payment is passed on to abs investors 9abss can be collateralized by either government student loans guaranteed by the u s department of education or private student loans 1011 the former have had a better repayment record and a lower risk of default benefits of investing in asset backed securitiesasset backed securities can offer several compelling reasons to invest in them abs can provide diversification opportunities beyond traditional asset classes like stocks and bonds you can get exposure to a diverse pool of underlying assets such as mortgages auto loans and credit card receivables that you shouldn t otherwise have traditional investment access in this also can give you access to different industries entirely abs can also have somewhat predictable cash flows the underlying assets typically generate steady income streams such as monthly mortgage payments or loan repayments passed through to abs holders this predictability can appeal to income oriented investors seeking stable returns remember that if the debtor defaults on their loan this cash flow could unexpectedly stop abs can offer enhanced yield potential compared to other fixed income securities with similar credit ratings this is because abs transactions may be structured where different tranches or slices of securities are created to appeal to investors with varying risk appetites if you want to take on more risk in exchange for potentially higher yields you can opt into that more conservative investors can opt for lower risk tranches with correspondingly lower yields last asset backed securities are frequently backed by collateral that can provide a degree of credit enhancement this collateralization helps mitigate credit risk to some extent as the collateral can be sold to make the missed payments on the asset because of this abs can be a popular choice that may have greater liquidity compared to other securities depending on the market conditions or structure of the abs risks associated with asset backed securitiesthere are also some risks to think about when investing in asset backed securities one primary risk is credit risk which refers to the possibility that borrowers underlying the abs may default on their payments this risk can vary depending on the credit quality of the underlying assets and the structure of the abs transaction another significant risk is prepayment risk particularly relevant in mortgage backed securities mbs prepayment risk arises when borrowers repay their loans earlier than expected such as during periods of falling interest rates this can disrupt the expected cash flows to abs holders it can also dramatically reduce the return on investment as an investor may have been hoping to general additional cash flow from interest payments that would have occurred had the debt not been prepaid market risk is another factor to consider as changes in market conditions interest rates or economic factors can affect the value and performance of abs as we ll look at later in the 2008 global financial crisis section poor valuations for the assets being backed could lead to upside loans when certain market conditions like this exist liquidity risk may arise if there is difficulty in selling abs positions quickly or at fair prices key players in the abs market industrythe asset backed securities abs market involves several key participants who each play a small part in the issuance trading and management of abs transactions here are the key players legal considerations in asset backed securitiesasset backed securities transactions involve several important legal considerations there are three main legal aspects of abs to keep in mind example of abs 2008 global financial crisis the 2007 2008 financial crisis was a culmination of factors rooted in the housing market bubble and financial market practices it began with years of low interest rates and loose lending standards which encouraged excessive borrowing and speculative investments in subprime mortgages mortgage backed securities bundled these loans and were sold to investors however as the housing bubble burst and homeowners defaulted on their mortgages the underlying value of mbs declined sharply investors including major financial institutions and global banks suddenly found themselves holding securities backed by increasingly risky loans this triggered a crisis of confidence in the financial markets as the true extent of losses became apparent leading to widespread panic and freezing of credit markets 12the crisis escalated in 2007 with the collapse of two bear stearns hedge funds heavily invested in subprime loans signaling broader market instability by 2008 the failures of major financial institutions like lehman brothers and the near collapse of others like bear stearns and merrill lynch highlighted the systemic risks posed by interconnected global financial 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