Asset-Backed Security
ABS represents a (partial) ownership stake in some real asset (such as credit card loans, mortgages, etc.).
- Therefore, it is not a derivative, since derivative implies no ownership.
The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans
- Also, more esoteric cash flows can be used, such as aircraft leases, royalty payments, or movie revenues
SPV (Special Purpose Vehicle)
For an ABS to arise, a separate institution called a Special Purpose Vehicle (SPV) is created to handle the securitization of the securities
- ex. this securitization process might be having a basket of houses investable by many people. Here, Securitization answers the question, "how do we allow thousands of people to each own a small percentage of thousands of houses?"
Upon selling these ABSs to the market, the proceeds are used to pay back the bank that created the underlying assets.
- The bank removes the value of the underlying asset from its balance sheet and receives cash in return from the SPV, upon sale of the ABSs.
- Thus, one incentive for banks to create securitized assets is to remove risky assets from their balance sheet by having another institution assume the credit risk, so that they (the banks) receive cash in return
Examples
There are 4 core asset classes financed through asset-backed securitizations:
- Home Equity Loan
- Auto loan
- Credit Card Receivables
- Student loans
Home Equity Loan (HEL)
A HEL is where the borrower uses the equity of his or her home as collateral. Securitization of the HEL can occur (resulting in an ABS), which is collateralized by the HELs themselves.
- These are currently the largest asset class within the ABS market
Auto Loan
Auto finance companies issue securities backed by underlying pools of auto-related loans. Auto loans are the second largest subsector in the ABS market
Credit Card Receivables
Student Loans
CDO (collateralized debt obligations)
Technically, ordinary CDOs are not derivatives. Their value is not derived from the assets they own, their value is the assets