What’s an Asset-Backed Security?
These securities are generated through the process of buying and bundling loans. The different loans involved in this can include residential mortgage loans, student loans, and even commercial loans. These bonds are created from different sorts of consumer debt. The income payments coming from an asset-backed security are a pool of assets that cannot be sold on their own, and instead they are bundled. When this happens, those assets are backed by securities, and they are sold to investors. Since these are bundled, many times the different loans inside will be put into different security categories based on potential risks and returns.
- One thing that separates asset-backed securities from other bonds is that the “creditworthiness” of the security is drawn from a source outside of the “payment ability” of the person originating the bond.
These kinds of bonds are generated when customers borrow money for one of several purposes (including a loan for purchasing a new car or a home-equity loan). The loans are then listed as “assets” on the books of whoever loaned them the money, such as a bank of the company providing the car financing. Those assets can then be bundled and sold.
One of the benefits of asset-backed securities is that using them can help to diversify a bigger pool of assets, because each asset represents only a small slice of a bigger set. Therefore, the risk is smaller in comparison since there are a variety of assets making up this complete pool.
- Some other kinds of assets that may be included in the pool are automobile loans, royalty payments, and payments from credit cards.
Most often, a special purpose vehicle is used for the purpose of securitizing the asset-backed securities. The goal of the special purpose vehicle is to generate and sell the securities and the money from that sale is used to pay the bank back for those assets. The assets are bundled together into a pool that’s geared towards appealing to investors.
- For investors, it’s important that the pool of securities is within their risk tolerance, and the bundles are often packaged in this way to encourage investor purchase.
When the securities (and the risk associated with those particular securities) are transferred to another entity, then the bank who originated the assets can remove them from their balance sheet, instead taking cash as the assets are sold. These kinds of transactions are preferred by banks because it can have positive impacts on their credit rating and cut down on the total amount of capital required by the bank.
- Asset-backed securities involve the movement of securities between entities and this process can help to diversify a larger asset pool.
What is a Mortgage-Backed Security?
Mortgage-backed securities are similar to bonds. In a bond situation, a corporation of government issues with a guarantee that a fixed amount will be paid as interested over a certain period of time. Mortgage-backed securities are typically purchased as a bundle when a security firm buys them from the primary lender. Investors are fronting the money for the purchase of these bonds in a sense, because the monthly payments you make (say, towards your mortgage) are used to pay revenue to those same investors.
- After the sale, monthly payments are made to the investors of the assets.
For lenders, selling the bundles is an important part of their operating equation, since it frees up their funds again and replenishes the amount of money they have on hand to make more loans available to other people. If they didn’t sell the loans, the primary lender would be stuck in a position with very little cash flow to make more loans available as your monthly payments trickled in. Selling these loans as mortgage-backed securities allows them to have a stream of business coming in and going out so that they can continue operating to provide more loans.
- Bundle sales are critical for provider banks and loan originators the opportunity to continue making loans available to other people
Part of the reason that mortgage-backed securities can hold some appeal for investors is due to the economic climate at the time. For example, if the housing market is experiencing positive gains while interests rates are law, mortgage-backed securities are seen as relatively low-risk, which entices investors to jump on board.
This cycle can only continue if the homeowners who received the mortgage continue to make their payments, because this continues the stream of revenue going through to the securities holder. If interest rates rise or the housing market begins to collapse, mortgage-backed securities are not as low-risk, driving away investor interest in the purchases.
- Investor interest in the products depends on several factors including their evaluation of the potential risk in the bundles and the current state of the market.