An Asset Backed Security (ABS) is a type of financial security supported by assets such as leases, loans, or receivables, excluding mortgage-backed securities and real estate. In the investment world, ABS offers an alternative to traditional corporate debt. They are similar to Mortgage Backed Securities (MBS), but the underlying assets differ. ABS can include credit card debt, leases, loans, royalties, and receivables from the issuing company, whereas MBS are backed by mortgages.
ABS provide issuers with a way to generate cash and offer yield-seeking investors a variety of income-generating assets. The underlying assets of ABS are generally not liquid on their own meaning they cannot be readily converted to cash on an individual basis but can be pooled and securitized to create a marketable financial security.
This process, known as securitization, allows asset owners to sell them in the market. Pools of assets can include car loans, home equity loans, student loans, credit card receivables, or other anticipated cash flows. The creativity of ABS issuers in structuring these securities is remarkable, with some ABS being based on unconventional income streams such as movie box office revenues, aircraft lease payments, royalties from creative works, and even cash flows from solar energy installations. In essence, any scenario that generates a predictable cash flow can potentially be packaged into an ABS through the securitization process.
To better grasp this complex concept, consider a hypothetical scenario involving a company called “Car Loans For Everybody.” This firm provides automobile loans to individuals, who then repay the borrowed amount plus interest in monthly installments. If Car Loans For Everybody becomes so successful that it exhausts its available capital for new loans, it might choose to sell its existing loan portfolio to an investment firm, let’s call it “Imperial Legends.” This transaction provides Car Loans For Everybody with fresh capital to continue its lending operations.
The securitization process begins when Imperial Legends acquires this loan portfolio. The investment firm would then organize the purchased loans into groups called tranches, each containing loans with similar characteristics such as interest rates, maturity dates, and expected default rates. Imperial Legends would subsequently issue new securities for each tranche, resembling bonds in many aspects. These securities are then sold to investors, who receive the cash flows from the underlying car loans, minus an administration fee retained by Imperial Legends to cover costs and generate profit.
Asset Backed Securities typically feature three classes of tranches: Class A, Class B, and Class C. The Class A tranche, being the most senior, is usually the largest and is structured to achieve a favorable investment rating, making it attractive to a wide range of investors. The Class B tranche carries a lower credit quality but offers a higher yield to compensate for the increased risk. The Class C tranche has the lowest credit rating and may be deemed too risky for some investors. In cases where the Class C tranche is unmarketable, the ABS issuer may retain it, collecting the monthly revenues and absorbing any potential losses.
