An Asset-Backed Security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets. Usually, one that generates a cash flow from debt, such as loans, leases, credit card balances or receivables. It takes the form of a Bond or Note-paying income at a fixed rate for a set amount of time, until maturity.
ABSs are created when a company sells its loans or other debts to an Issuer, a financial institution that then packages them into a portfolio to sell to investors. Pooling assets into an ABS is a process called securitization. ABSs appeal to income-oriented investors as they pay a steady stream of interest like bonds. Mortgage-backed securities and collateralized debt obligations can be considered types of ABS.
ABSs are therefore created and issued by a business, Special Purpose Vehicle (SPV), that is established solely to issue securities based on assets, receivables, or loans and to either remove assets from the balance sheet of the sponsor or to profit from the cash flow difference of income that it receives from the investors of its securities, as well as from the cash flow of its underlying assets and the expenses that it must pay out.
The most compelling reason for investing in ABSs is their higher rate of return relative to other assets of comparable credit risk.
Generally, institutional investors are legally compelled to buy only investment-grade securities, because they act as financial fiduciaries of others. Therefore, having a high credit rating is considered a prerequisite for the profitability of ABSs.
Credit Raters look into about four major areas to determine the creditworthiness of the security namely:
1. The parties to the deal, which include the Sponsors and the management of the Issuer
2. Legal review of the business and documentation
3. The credit quality of the underlying collateral and;
4. The Structure of the security itself including its cash flow and the use of credit enhancements.
The Sponsors of ABSs are the creators of the SPV entity which packages the loans, receivables, or other assets into securities. While the Servicers are the companies servicing the loans or receivables by receiving the payments from the borrowers, providing customer service, and collecting on delinquent accounts. Sometimes, Servicers may also be the Sponsors of the ABSs.
Like every other business, the financial condition, company and management experience, operating controls, current and projected business, the use of technology to reduce costs and improve quality, and performance history, especially regarding the assets being used as collateral are equally important in determining the credit quality of sponsors and servicers.
Asset Managers are an important consideration for those securities, such as Collateralized Debt Obligations (CDOs), where they have an important role in selecting the securities, managing the portfolio, and monitoring its credit quality. To maintain credit ratings, the Asset Manager must perform various credit quality tests periodically, and if any of the tests fail, the manager must take steps to protect investors.
The main determinant of credit quality is the risk of default of the underlying asset and the amount of recovery that is likely after recovery expenses have been paid. This is usually determined by the information that has been gleaned from prior securitizations of the same type of assets.