What are Asset Backed Securities (ABS)?
Asset backed securities (ABS) are securities backed by the cash flows of a pool of assets. Home equity loans, auto loans, credit card receivables, and student loans commonly back this class of securities. However, nearly any cash-producing financial asset can be securitized.
Asset Backed Securities Example
Let's assume Company XYZ is in the business of making auto loans. When it makes a loan, it gives cash to the borrower and the borrower agrees to repay that amount with interest.
But if Company XYZ wants to make more loans, it may find itself needing cash to do so. This is where asset-backed securities come in.
Company XYZ can sell its auto loans to ABC Investments. As a result, Company XYZ receives cash to make more loans, and it transfers those auto loans from its balance sheet to ABC's balance sheet.
ABC Investments may group these auto loans into tranches--groups of loans that may have common characteristics such as maturity or delinquency risk. ABC then issues a security similar to a bond that essentially keeps an administrative fee for itself and then "forwards" the remaining proceeds from the auto loans to the investors.
The asset-backed securities trade on various exchanges, similar to any other security. Public ABS offerings must satisfy SEC requirements including providing regular financial disclosures to investors. Ratings agencies may assign a rating to the securities based largely on the probability that the underlying expected cash flows will materialize. In some cases, the ABS will receive higher credit ratings than the issuer has for itself; this is a reflection of the risk associated with the certainty of the ABS's underlying cash flows.
ABS Definition - Why it Matters in Finance
It's important to understand the definition of ABS because asset backed securities have several important benefits. Primarily, they give lenders a way to obtain cash for more lending, and they offer investors a way to invest in a diversified group of income-producing assets.
The ABS market is not always as overvalued as the markets for other income-producing securities such as corporate bonds or Treasuries. For this reason, investors must carefully examine the features and underlying assets of a particular ABS before investing.
Note that ABS are subject to prepayment risk; that is, if any of the borrowers pay their cars off early, this reduces the cash flows ultimately going to ABS investors.