Asset-backed security

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 include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and 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.

Trading asset-backed securities

"In the United States, the process for issuing asset-backed securities in the primary market is similar to that of issuing other securities, such as corporate bonds, and is governed by the Securities Act of 1933, and the Securities Exchange Act of 1934, as amended. Publicly issued asset-backed securities have to satisfy standard SEC registration and disclosure requirements, and have to file periodic financial statements.

"The Process of trading asset-backed securities in the secondary market is similar to that of trading corporate bonds, and also to some extent, mortgage-backed securities. Most of the trading is done in over-the-counter markets, with telephone quotes on a security basis. There appear to be no publicly available measures of trading volume, or of number of dealers trading in these securities.

"A survey by the Bond Market Association shows that at the end of 2004, in the United States and Europe there were 74 electronic trading platforms for trading fixed-income securities and derivatives, with 5 platforms for asset-backed securities in the United States, and 8 in Europe.

"Discussions with market participants show that compared to Treasury securities and mortgage-backed securities, many asset-backed securities are not liquid, and their prices are not transparent. This is partly because asset-backed securities are not as standardized as Treasury securities, or even mortgage-backed securities, and investors have to evaluate the different structures, maturity profiles, credit enhancements, and other features of an asset-backed security before trading it."

The "price" of an asset-backed security is usually quoted as a spread to a corresponding swap rate. For example, the price of a credit card-backed, AAA rated security with a two-year maturity by a benchmark issuer might be quoted at 5 basis points (or less) to the two-year swap rate."

"Indeed, market participants sometimes view the highest-rated credit card and automobile securities as having default risk close to that of the highest-rated mortgage-backed securities, which are reportedly viewed as substitute for the default risk-free Treasury securities.