Asset Backed Securities

Asset Backed Securities Definition

An asset backed security is a security whose value is backed by the cash flows of a pool of receivables, small and illiquid assets or financial assets that cannot be sold individually. These small and illiquid assets, when pooled together into financial instruments, can be purchased by general investors, thus diversifying the risk of investing in such assets as each security will be a part of the total value of the assets.

The selling of the pool of the underlying assets to general investors is called Securitization. The securitization of asset backed securities is generally handled by a separate institution known as “Special Purposes Vehicle”, which sells the securities and pay the amount to the bank which created the underlying assets. The Special Purposes Vehicle transfers the credit risk of the underlying assets often to an insurance company for which Special Purposes Vehicle has to pay some premium. It is also responsible for distributing the proceeds of the sale of the securities. It also insulates investors from credit risk of loan originator.

When Special Purposes Vehicle transfers the credit risk to another institution like an insurance company, the bank which created the underlying assets (known as originating bank) gets cash when the asset-backed securities are sold to the investors, leading to an improvement in credit rating. If the credit rating is higher, Special Purpose Vehicle and the originating bank can charge more prices for the securities.

Types of Asset Backed Security:

Asset-based Securities are of the following types:

Home Equity Loans: Securities backed by Home Equity Loans are the largest sector in the Asset-backed Securities market.
Auto Loans: Auto loans, the second largest sub-sector in the Asset-based Securities market, are categorized into prime Auto Asset-based Securities, non-prime Auto Asset-based Securities and Sub-prime Auto Asset-based Securities. Prime Auto Asset-based Securities are backed by loans that are given to the people who have good credit history while non-Prime Auto Asset-based Securities are backed by loans given to the people who have an average credit history while Sub-Prime Auto Asset-based Securities are backed by loans given to the people who either have lower income or poor credit history.
Credit Card receivables: Securities collateralized by Credit card receivables were first launched in 1987. Credit Card holders can take loans till a credit limit and they have to pay principal, interest and basic monthly payments. These form the third largest sector in Federal Family Education Loan Program.
Student loans: It is the fourth major sub-sector for asset backed securities market. Student loans are of two types – Federal Family Education Loan Program (FFELP) and Private Student Loans. United States’ department of Education guarantees FFELP loans while Private student loans are taken by students since loans taken through Federal Family Education Loan Program are not sufficient enough because of increasing tuition. In United States, there is Government-sponsored student loan marketing Association which securitizes groups of student loans.
Equipment leases and loans, royalties, aircraft leases and manufactured housing loans are some of the other assets which can be securitized.

Trading Asset Backed Securities

Asset-based Securities, which are publicly issued, have to fulfill SEC registration and issue financial statements regularly.

Advantages of Asset Backed Securities

Following are the advantages of Asset-based Securities:

Asset-based Securities combines those assets which could not be sold individually in their present form.
Selling these assets to a separate institution reduces the risks faced by loan originator and allows them to originate more loans.
Loan originators earn not only by originating loans but also by servicing assets.