Asset-Backed Security (ABS)

An asset-backed security (ABS) is a bond whose interest and principal are paid from the cash flows of a defined pool of financial assets, such as car loans, credit card balances, student loans, equipment leases or trade receivables. The assets are held by a separate legal entity, so investors look to the pool, and not to the company that originated the loans, for repayment.

ABS are the product of securitisation. In the widest sense the term covers every securitised bond. In market usage it usually means securities backed by consumer and commercial assets other than property loans, which are classed separately as the mortgage-backed security (MBS). Bonds backed by corporate loans form a further category, the collateralised loan obligation (CLO).

A lender, called the originator, selects a pool of loans that meet set criteria and sells them to a special purpose vehicle (SPV). The sale is designed as a true sale, so that the assets are beyond the reach of the originator's creditors if it fails. The vehicle pays for the pool by issuing notes to investors.

The originator normally continues to collect payments from borrowers as servicer, for a fee, and passes them to the vehicle. A trustee holds security over the assets for noteholders, and a back-up servicer may be named in case the first one fails. Collections are distributed on each payment date in a fixed order of priority, known as the securitisation waterfall: senior fees first, then interest and principal on the notes in order of rank.

Pools of short-lived assets, such as credit card receivables, are often revolving. For a set period, principal collections are used to buy new receivables, and only afterwards are they used to repay the notes.

The notes are divided into classes with different rankings, a technique called tranching. Losses on the pool are borne first by the most junior class and only reach a higher class once those below it are exhausted. The usual layers are the senior tranche, one or more levels of mezzanine tranche, and a first-loss piece or equity tranche, often kept by the originator.

Subordination is one form of credit enhancement. Others include:

• Overcollateralisation. The pool is worth more than the notes issued against it.
• Excess spread. Borrowers pay more interest than the notes cost, and the difference, the excess spread, absorbs losses first.
• Reserve accounts. Cash is set aside at closing or built up from collections to cover shortfalls.
• Triggers. If arrears or losses pass set levels, cash is diverted to repay senior notes early.

These features allow senior notes to carry a higher credit rating than the originator itself.

For originators, ABS are a source of funding that depends on the quality of the assets and not on their own credit standing. Selling the loans can also free up capital and transfer risk, provided regulators accept that the risk has genuinely moved. Car manufacturers' finance arms, banks, card issuers and specialist lenders are regular issuers.

Investors obtain exposure to diversified pools of consumer or business credit, a choice of risk levels within one deal, and yields that are typically higher than those on corporate bonds of the same rating. Most ABS repay principal gradually and many pay a floating rate.

The main risk is that defaults in the pool exceed the protection beneath a given class. Because the notes repay as the loans do, investors also face prepayment risk and uncertainty about the average life of their holding. Other risks arise from the parties to the deal: a servicer that fails, a bank holding the collection account, or a swap provider. Complex or opaque pools are hard to analyse, and in stressed markets ABS can become difficult to sell.

These weaknesses were exposed in the financial crisis of 2007 to 2009. Securities backed by US subprime mortgages, and the collateralised debt obligations built from them, suffered heavy losses, and ratings proved unreliable. Plain consumer ABS such as car loan and credit card deals performed far better, but the whole market shrank sharply.

Reforms since then have aimed to align the interests of originators with those of investors and to improve disclosure. In the United States, rules made under the Dodd-Frank Act require the sponsor of most securitisations to retain at least 5% of the credit risk. The European Union's Securitisation Regulation, which has applied since 2019, sets a similar 5% retention rule, requires loan-level disclosure and due diligence by investors, and created a label for "simple, transparent and standardised" deals that receive more favourable capital treatment. The Basel framework revised the capital that banks must hold against securitisation positions. A related structure in which the risk is transferred by guarantee or derivative, without selling the assets, is the synthetic securitisation.

• U.S. Securities and Exchange Commission
• European Securities and Markets Authority