Definition
An Asset-Backed Security (ABS) is a type of financial instrument that is created by pooling various types of debt (such as mortgages, auto loans, credit card receivables, or student loans) and selling them as bonds to investors. These securities are used by financial institutions to remove these assets from their balance sheets, thereby reducing their credit risk and providing liquid assets to investors.
Examples
- Collateralized Mortgage Obligation (CMO): A type of ABS that is backed by mortgage loans. The payments on the underlying mortgages are segmented into different tranches, each with its level of risk and expected returns.
- Mortgage-Backed Security (MBS): Another form of ABS, specifically backed by a pool of mortgage loans. Investors receive periodic payments derived from the interest and principal on the underlying mortgage loans.
- Credit Card ABS: Securities backed by the receivables of credit card accounts. The cash flows from credit card payments, including interest and principal, are passed through to the investors.
Frequently Asked Questions (FAQs)
What types of loans can back an ABS?
- ABS can be backed by various types of receivables, including home equity loans, auto loans, student loans, consumer loans, and credit card receivables.
How does credit enhancement work in ABS?
- Credit enhancement techniques are used to improve the credit quality of an ABS. These can include over-collateralization, where extra collateral is provided, or external credit enhancements like bank letters of credit, insurance, or guarantees from third parties.
Why invest in Asset-Backed Securities?
- Investors are attracted to ABS because they offer higher yields than government securities and provide diversification by investing in different types of asset pools.
What are the risks associated with ABS?
- Key risks include credit risk (the risk of default on the underlying assets), prepayment risk (the risk that the underlying loans will be paid off early), and interest rate risk (changes in interest rates can affect the value of the securities).
Related Terms with Definitions
- Collateralized Mortgage Obligation (CMO): A type of security backed by a pool of mortgage loans segmented into tranches with varying levels of risk and returns.
- Mortgage-Backed Security (MBS): Securities created from pools of mortgage loans that provide investors with periodic payments derived from the mortgage repayments.
- Credit Enhancement: Techniques used to improve the credit quality of financial securities, increasing their attractiveness to investors.
- Prepayment Risk: The risk that the underlying loans of ABS may be paid off earlier than expected, potentially leading to a lower return for investors.
- Credit Risk: The risk that the borrower of the underlying asset may default on their payments.
Online Resources
- Securities and Exchange Commission (SEC): A comprehensive resource for understanding securities regulations, including ABS.
- Investopedia: An educational website with detailed articles and tutorials on asset-backed securities.
- Financial Industry Regulatory Authority (FINRA): Offers investor alerts, including insights into investing in asset-backed securities.
References
- Securities and Exchange Commission. “Asset-Backed Securities.” SEC Website.
- Investopedia. “What is an Asset-Backed Security (ABS)?” Investopedia.com.
- Financial Industry Regulatory Authority. “Investor Alert on Asset-Backed Securities.” FINRA.org.
Suggested Books for Further Studies
- “Asset Securitization: Theory and Practice” by Anand K. Bhattacharya and Frank J. Fabozzi
- “The Handbook of Fixed Income Securities” by Frank J. Fabozzi
- “Asset-Backed Securities” by William J. McDonald, Frank J. Fabozzi, and Charles H. Brock
Real Estate Basics: Asset-Backed Security (ABS) Fundamentals Quiz
### What is an asset-backed security (ABS)?
- [x] A financial instrument backed by a pool of various types of assets.
- [ ] A security that represents ownership in a tangible asset like real estate.
- [ ] A government bond.
- [ ] A type of unsecured loan.
> **Explanation:** An ABS is backed by a pool of assets such as loans, mortgages, or receivables, and is sold to investors as a bond.
### Which of the following is NOT a common type of asset backing ABS?
- [ ] Mortgages
- [ ] Auto Loans
- [ ] Student Loans
- [x] Government bonds
> **Explanation:** Government bonds do not typically back ABS; instead, mortgages, auto loans, and student loans are common types.
### What is a common reason financial institutions issue ABS?
- [x] To reduce credit risk on their balance sheets.
- [ ] To save on taxation.
- [ ] To eliminate all debt.
- [ ] To ensure a fixed rate of return.
> **Explanation:** Financial institutions issue ABS to reduce credit risk on their balance sheets by transferring the risk to investors.
### Which of the following improves the credit quality of ABS?
- [ ] Guaranteed returns.
- [ ] Bigger asset pools.
- [x] Credit enhancements like bank letters of credit or insurance.
- [ ] Shorter maturity periods.
> **Explanation:** Credit enhancements such as bank letters of credit or insurance improve the credit quality of ABS, making them more attractive to investors.
### What type of risk is associated with the early pay off of underlying loans in ABS?
- [ ] Credit risk
- [x] Prepayment risk
- [ ] Liquidity risk
- [ ] Default risk
> **Explanation:** Prepayment risk occurs when underlying loans are paid off earlier than expected, affecting the yields for investors.
### Who benefits from the regular cash flows generated by ABS?
- [x] Investors
- [ ] Loan originators
- [ ] Borrowers
- [ ] Government bodies
> **Explanation:** Investors benefit from the regular cash flows generated by ABS, which come from the repayments of the underlying loans or receivables.
### How can institutions boost investor confidence in an ABS?
- [ ] Reducing the interest rates
- [ ] Collateralizing with fewer loans
- [x] Providing credit enhancements like bank letters of credit
- [ ] Minimizing disclosures
> **Explanation:** Providing credit enhancements like bank letters of credit can boost investor confidence by reducing the risk associated with the ABS.
### What kind of ABS is specifically backed by mortgage loans?
- [ ] Credit card ABS
- [ ] Auto loan ABS
- [x] Mortgage-backed security (MBS)
- [ ] Student loan ABS
> **Explanation:** Mortgage-backed securities (MBS) are specifically backed by pools of mortgage loans.
### Why do investors prefer ABS over government securities?
- [ ] Because they are more secure.
- [ ] Due to their tax benefits.
- [x] They offer higher yields.
- [ ] They are not subject to market risks.
> **Explanation:** Investors prefer ABS over government securities because ABS usually offer higher yields, compensating for their increased risk.
### Which of the following is a potential disadvantage of investing in ABS?
- [ ] Diversification benefits
- [ ] Liquidity
- [ ] Higher interest rates
- [x] Credit risks associated with the underlying assets
> **Explanation:** A potential disadvantage of investing in ABS is the credit risks associated with the underlying assets, which investors must carefully assess.
