Asset-Backed Securities
Asset-backed securities refer to investment vehicles that are based on pools of assets, or collateralized by the cash flows from a specified pool of assets, often some type of loans. When assets are pooled this way, otherwise minor and uneconomical investments can be made worthwhile, while also reducing risk by diversifying the underlying assets.
The asset pool on which asset-backed securities are based can include credit card payments, auto loans, and mortgages, as well as cash flows such as aircraft leases, royalty payments and movie revenues. Typically, the securitized assets might be highly illiquid and private in nature.
The types of securities that are commonly pooled to create asset-based securities include:- Home equity loans: Home equity loans make up most asset-backed securities. Originally, subprime, second lien home equity loans accounted for most of these types of securities, but first lien loans now make up the majority.
- Auto loans: The second largest subsector in the asset-based security market is auto loans. These types of asset-backed securities are classified into three categories: prime, nonprime, and subprime.
- Credit card receivables: Pools of credit card receivables have made up asset based securities since 1987.
- Student Loans: Federal Family Education Loan Program (FFELP) loans are the most common form of student loans and are guaranteed by the U.S. Department of Education at rates ranging from 95%-98%. Asset-based securities based on FFELP loans have historically been very good and investors rate of return has been excellent. A second, and faster growing, portion of the student loan market consists of non-FFELP or private student loans.
- Others: Other pools of assets that can be used to collateralize these securities include: manufactured housing loans, equipment leases and loans, aircraft leases, trade receivables, dealer floor plan loans, and royalties. Intangibles are another emerging asset class.
Asset-backed securities became popular because investors can realize several advantages by securitizing assets rather than keeping them on their books. For example, by packaging their portfolios of credit card receivables as securities, major commercial banks have been able to reduce the amount of capital they would otherwise have to maintain under new, stringent capital guidelines mandated by bank regulators.
In some cases an asset-backed security can be used as credit enhancement by creating a investment that has a higher rating than the issuing company which monetizes its assets. This allows it to pay a lower rate of interest than would be possible via a secured bank loan or debt issuance.
The value of an asset-backed security is dependant on assets in the pool continuing to create a cash flow. For instance, those backed on mortgages are dependent on loan holders making their payments. Unfortunately, when the housing bubble burst in 2007 and foreclosures spread, the realization of the uncertainty associated with the various form of asset-backed securities led to financial collapse.