Asset-Backed Security Basics

by Gail Stone 01/05/2020

Image by Gino Crescoli from Pixabay

The common understanding of an asset-based debt is a loan meant to be repaid with interest, over time, and backed by a physical asset such as a building or a car. The asset serves as collateral that can be claimed by the lender in case of borrower default.

An Asset-Based Security (ABS), however, in investment terminology, is somewhat different.

Even though the common understanding of an Asset-Backed Security (ABS) might be a loan that is based on an actual asset, such as a home or an automobile, that is only partially the case in investment terminology. By definition, the ABS represents a pool of debt -- usually a group of individual loans -- that can include any type of debt other than mortgages. It may include loans that are backed by real property, such as equipment, land, buildings, or business inventory, but not necessarily.

Mortgages are specifically excluded and classed separately today. The ABS evolved from the mortgage-backed securities that were first introduced in the 1980s, but a debt secured by a mortgage is today known as Collateralized Debt Obligation (CDO). To make it more confusing, a CDO is a specific type of ABS.

An ABS represents other types of debt. Liability might be associated with an automobile loan, student loan debt, credit card debt, home equity loan or other types of loan debt that are to be repaid, with interest, over a specified period of time. Investors in asset-based securities assume the risk; the anticipation is that payment of outstanding principal and interest will be repaid as scheduled, so that investors will earn a reasonable rate of return. The risk is that borrowers may default on the loans, or that a collection process will delay repayment and involve unexpected costs. 

The relative risk and anticipated return depends on the way such loans are packaged and sold. And the packaging depends in part on the reasons an original lender has for wanting to transfer the liability.

The original lender, often a small bank, credit union or other type of funding agency, will "sell the paper" as part of a package to a larger investor. This is accomplished in many ways and for a variety of reasons. Sometimes, it is to better the creditor's financial position or to comply with government rules regarding loan percentages and cash reserves. Such a sale may also be an attempt to dispose of non-performing loans by transferring the burden of collections to another entity. 

Investment institutions package loans based on risk assessment. The loans are separated into three classes known as tranches. Risk and potential return are proportional: A higher-risk tranch also promises higher yield, while lower risk invariably holds potential for a lower interest rate return on investment.

Working with a knowledgeable financial advisor is recommended if you are interested in ABS investing. Almost any brokerage firm can be used for such investment.  

About the Author
Author

Gail Stone

Dedication, knowledge and her 'beyond the call of duty' approach enables Gail to sell successfully both to the first time buyer and the experienced seller. Her honesty and perseverance have served her clients extremely well. I am proud to say I have been with the firm since 1985 and have been a Stamford resident for 34 years. My former careers have been a high school math teacher and a computer programmer. I love helping people with their housing needs and feel I am able to help them maximize their purchases and sales.