What are asset-backed securities?

Buying asset-backed securities (ABSs) is a way to invest in a pool of underlying assets that generate regular income, and hence, regular returns

Asset-backed securities might seem like every other investment vehicle, but they are not. They are actually incredibly complex instruments designed by financial institutions for risk=taking investors.

In this article, we’re going to understand what ABSs are, how they work, and the pros and cons of investing in them.

Understanding asset-backed securities

Asset-backed securities are financial instruments that are collateralised by other underlying assets – typically those that generate a regular cash flow. These could be several forms of debt or any other sort of receivables.

Asset-backed securities are a way for investors to invest in assets like corporate bonds or funds that in turn invest in other bonds.

How do ABSs work?

Let’s understand ABSs from the perspective of bank loans. Keep in mind that the following logic can be applied to almost any other security that yields a regular cash flow.

When you take a loan from a bank, it’s a liability for you that you need to pay back. For the bank, however, it’s an asset that generates regular incomes (your loan payments). When several of these assets get collected on the bank’s balance sheet, they might want to sell these loans to someone else and get their money back.

This is how the bank does it:

• Pooling the loans under one bracket: The bank groups similar loans into a pool categorised usually by the purpose of the loan – housing, car, student loans, etc. This pool can also encompass other assets like credit card receivables or even business loans.
  
• A Special Purpose Entity (SPE) is created: A new legal entity, a SPE, is created to hold this asset pool the bank created. This is done to ensure that any contingencies that arise from this pool doesn’t affect the original bank or its assets in any way.
  
• Structuring the deal for investors: The cash flow generated from these underlying loans, which are payments made by debtors, are used to make payments to investors who buy the pool. Before that, however, this pool is divided into several levels of risk (also called tranches) so investors can take as much or as little risk as they want.
  
• Crediting the tranches: Tranches are like slices of a cake, each with a different level of priority in receiving payments. Senior tranches receive principal and interest first, offering lower returns but higher stability. Junior tranches get paid later, potentially offering higher returns but carrying greater risk of default if there are shortfalls in the underlying assets.
  
• Selling the pool: Now that the backend work is done, the SPE issues securities that are backed by these loan assets. These can then be bought by institutional investors, mutual funds, or even retail investors who seek regular income or diversification.

What are the benefits and risks of investing in ABSs?

The pros

On paper, there are several benefits that these asset-backed securities offer – they help banks get their original capital back which they can now lend to other borrowers. In the long run, this stimulates economic activity.

The securitisation of these assets also means that the bank spreads the risk of a bad loan amongst several investors in a risky tranche.

From the investor’s point-of-view, ABSs provide exposure to a wide and diversified pool of assets. They can also choose the risk they’re willing to take owing to the tranched structure – getting rewarded with a higher return for taking a higher risk and vice versa.

Some investors also value regular cash flows they get from these instruments, which they can use to supplement their income passively.

The cons

ABSs come with significant credit risk. Credit risk is the risk that the loans, which form the core of this investment product, might go unserviced by borrowers. While one or two defaults here and there might not significantly damage the integrity of an ABS, large-scale defaults might.

When borrowers stop paying, the total cash flow that investors are entitled to vanishes, causing principal losses – first to junior tranches, and then to the senior ones.

The misuse of ABSs was also one of the biggest reasons for the 2008 financial crisis. Subprime mortgages, known for their higher risk of default, were bundled into complex ABSs and sold to investors who thought they were solid. 

So, when housing prices fell and defaults surged, the interconnected risks in these securities amplified, which led to cascading losses for investors and a liquidity crisis that crippled the financial system.

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