Asset-backed securities

Asset-backed securities (ABS) are financial instruments whose value and income payments are derived from and collateralized by a specified pool of underlying assets. These assets are typically illiquid and cannot be sold individually, making securitization an effective way to make them available to investors.
Asset-backed securities are created by buying and bundling loans – such as residential mortgage loans, commercial loans or student loans – and creating securities backed by those assets, which are then sold to investors. Often, a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities. ABS are created through a process called securitization, where an entity (often called a special purpose vehicle or SPV) purchases a pool of assets from an originator and issues securities backed by the cash flows from those assets. The SPV structures the securities into different tranches, typically categorized as senior (A), mezzanine (B), and junior (C), each with varying levels of risk and return to cater to different investor preferences.
Consumer-related ABS are generally perceived to be safe assets because their short-duration makes cash flows more predictable, keeps ratings stable and puts them in a class of alternatives to cash and Treasuries. However, the 2008 credit crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets.
The Dodd-Frank Act, signed in 2010, imposed new requirements on ABS, including business conduct standards, credit risk retention and reporting.
== History of Asset-Backed Securities ==
Asset securitization has its roots in the structured financing of mortgage pools that began in the 1970s. Prior to this, banks primarily operated as portfolio lenders, holding loans on their books until maturity or repayment. These loans were funded mainly by deposits and sometimes by debt that was a direct obligation of the bank.
In the post-World War II era, depository institutions struggled to keep up with rising demand for housing credit. To attract investors and increase mortgage funding sources, investment bankers developed a new investment vehicle that isolated defined mortgage pools, segmented credit risk, and structured cash flows from the underlying loans. This process of mortgage securitization took several years to refine, but loan originators quickly realized it could be applied to other types of loans as well.
The modern asset-backed securities (ABS) market emerged in the mid-1980s, driven by advances in technology and increasingly sophisticated investors. In 1985, securitization techniques from the mortgage market were first applied to non-mortgage assets, specifically automobile loans. Auto loans were well-suited for structured finance due to their shorter maturities and long statistical performance histories.
A major milestone came in 1986 with the first significant bank credit card securitization - a $50 million private placement of credit card receivables. This transaction demonstrated that loan pools with higher expected losses could support asset sales if yields were high enough. It also allowed banks to achieve sales treatment for accounting and regulatory purposes while retaining origination and servicing fees.
Following these early successes, the types of assets being securitized expanded rapidly. Commercial real estate emerged as one of the fastest-growing segments in the 1990s and 2000s. The ABS market has continued to evolve, with ongoing innovation in structuring cash flows and credit enhancements to securitize increasingly diverse asset types.
== Key Participants ==
* The ABS market involves several key players:
* Issuers: Originate the underlying assets
* Investors: Purchase the ABS
* Underwriters: Facilitate the issuance of ABS
* Servicers Manage the underlying assets
== Benefits and Risks ==
ABS offer several benefits to both issuers and investors:
* For issuers: Provides funding, reduces credit risk, and potentially improves balance sheet metrics
* For investors: Offers access to diversified asset pools, potentially higher yields, and customized risk-return profiles
However, the 2007-2008 financial crisis highlighted significant risks associated with certain types of ABS, particularly those backed by subprime mortgages.
== Regulatory Considerations ==
Following the financial crisis, regulators have increased scrutiny of ABS. The U.S. Securities and Exchange Commission (SEC) has proposed rules to enhance transparency and investor protection in ABS offerings.
== Market Significance ==
Asset securitization has become a crucial component of capital markets since its inception in the 1970s. It has grown rapidly, expanding to encompass a wide variety of asset types beyond its original focus on mortgage-backed securities.
== References ==
Category:Loans
Category:Securities