The term 'Asset Backed Security (ABS)' is included in the Corporate Finance edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Check for lowest price here...
An Asset Backed Security is also known by its acronym ABS. This refers to a type of financial security. These are commonly backed up using either a lease, a loan, or receivables against company assets (which would not include either mortgage backed securities or real estate). With the world of investing, such ABS provide other choices for those who wish to invest in something other than common corporate debt issues.
It is interesting to note that these Asset Backed Securities are more or less identical to MBS Mortgage Backed Securities. The primary difference lies in the securities which back the two financial instruments. With the ABS, they can include credit card debt, leases, loans, royalties, and even the receivables of the company issuing the debt. Yet these mortgage based securities may never underlie the ABS.
Such an Asset Backed Security delivers to the issuer of the security a means of creating more cash for the business. It allows yield hungry investors the chance to sink their money into a great range of assets which generate income. It is worth noting that most of these underlying assets will not be liquid. This means that they can not be readily sold as stand alone assets. Yet in pooling such assets into a single conglomeration, a financial security may be created. This is done in the process referred to as securitization. This permits the asset owner to employ them in a marketable fashion.
Among the assets of such pools could be car loans, home equity loans, student loans, credit card receivables, or other anticipated cash flow items. The capacity of Asset Backed Security issuers to be creative should never be underestimated. There have even been ABS which were established utilizing the cash flow generated by movie release revenues, aircraft leases, creative works and other forms of royalty payments, and even solar energy photovoltaic revenue streams. Practically any scenario where cash is produced can be packaged up via securitization into an ABS.
It is often helpful to consider an example of this somewhat complicated Asset Backed Security topic. Consider the case of a fictitious firm Car Loans For Everybody. When individuals wish to borrow funds to purchase a car, Car Loans For Everybody will issue them the cash in a check. The individual will have to pay back the loan along with a specified interest amount at a certain time in monthly installments. It could be that Car Loans is so successful at making automobile loans that they deplete their cash reserves and can no longer issue additional loans. They have the ability to sell off their present book of loans to the fictitious investment firm Imperial Legends. Imperial Legends will then provide them with the cash they need to continue issuing new loans.
This is only where the securitization process begins. Imperial Legends investment firm would then arrange the bought out loans into a collection of parcels known in the business as tranches. A tranche effectively is a batch of loans that posses similar features. This would include interest rates, maturity dates, and anticipated rates of delinquency. After this, the Imperial Legends firm would offer new securities with features much like bonds in every tranche they created.
Finally, investors will buy such securities. They obtain the underlying cash flow out of the pool of car loans, less the administration fee, which Imperial Legends will keep to cover their costs and towards their profit.
There are three typical types of tranches in an Asset Backed Security. These are commonly referred to as Class A, Class B, and Class C. Senior most tranches belong to Class A. They are generally the biggest tranche. They will be structured in such a way as to obtain a decent investment rating so that they are easily marketable to investors.
With the Class B tranche, the credit quality will necessarily be lower. This inversely means that the yield will be higher than that of the senior tranche. Since the risk is greater, investors need to be compensated for their appropriate risk of defaults.
Class C tranche has the lowest credit rating of all. It could be the credit quality is so poor that investors will refuse to consider it altogether. In such cases, the ABS issuer then holds the Class C tranche, collects the incoming revenues every month, and absorbs any losses themselves.