Asset-backed security

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An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized (or "backed") by a specified pool of underlying assets.

The pool of assets is typically a group of small and illiquid assets which are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can vary from common payments on credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments, or movie revenues.

Often a separate institution, called a special-purpose vehicle, is created to handle the securitization of asset-backed securities. The special-purpose vehicle, which creates and sells the securities, uses the proceeds of the sale to pay back the bank that created, or originated, the underlying assets.

The special-purpose vehicle is responsible for "bundling" the underlying assets into a specified pool that will fit the risk preferences and other needs of investors who might want to buy the securities, for managing credit risk – often by transferring it to an insurance company after paying a premium – and for distributing payments from the securities. As long as the credit risk of the underlying assets is transferred to another institution, the originating bank removes the value of the underlying assets from its balance sheet and receives cash in return as the asset-backed securities are sold, a transaction which can improve its credit rating and reduce the amount of capital that it needs. In this case, a credit rating of the asset-backed securities would be based only on the assets and liabilities of the special-purpose vehicle, and this rating could be higher than if the originating bank issued the securities because the risk of the asset-backed securities would no longer be associated with other risks that the originating bank might bear. A higher credit rating could allow the special-purpose vehicle and, by extension, the originating institution to pay a lower interest rate (and hence, charge a higher price) on the asset-backed securities than if the originating institution borrowed funds or issued bonds.

Thus, one incentive for banks to create securitized assets is to remove risky assets from their balance sheet by having another institution assume the credit risk, so that they (the banks) receive cash in return. This allows banks to invest more of their capital in new loans or other assets and possibly have a lower capital requirement.