Asset-Backed Security (ABS)

An asset-backed security (ABS) is a financial security collateralized by a pool of assets such as loans, leases, credit card debt, royalties or receivables. For investors, asset-backed securities are an alternative to investing in corporate debt. An ABS is similar to a mortgage-backed security, except that the underlying securities are not mortgage-based.

Asset-backed securities allow issuers to generate more cash, which, in turn, is used for more lending, while giving investors the opportunity to invest in a wide variety of income-generating assets. Usually, the underlying assets of an ABS are illiquid and can't be sold on their own. However, pooling the assets together and creating a financial security, a process called securitization, enables the owner of the assets to make them marketable. The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans or other expected cash flows. Issuers of ABS can be as creative as they desire. For example, ABS have been created based on cash flows from movie revenues, royalty payments, aircraft leases and solar photovoltaics. Just about any cash-producing situation can be securitized into an ABS.

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 runs out of cash to continue making more loans. Company X can then package its current loans and sell them to Investment Firm X, thus receiving cash that it can use to make more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches are groups of loans with similar characteristics, such as maturity, interest rate and expected delinquency rate. Next, Investment Firm X will issue securities that are similar to typical bonds on each tranche it creates.

Individual 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 tranches: class 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. 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.