Legal Definitions - asset-backed security

Asset-Backed Security (ABS)

An Asset-Backed Security (ABS) is a type of financial investment whose value and income payments are derived from and collateralized by a pool of underlying assets. Instead of a company holding onto individual loans or receivables, it bundles many similar assets together and sells them as a single security to investors. The cash flow generated by these underlying assets (such as loan payments) is then used to pay the investors who bought the ABS.

This process allows originators of loans (like banks or finance companies) to remove assets from their balance sheets, freeing up capital to issue more loans, while providing investors with a way to invest in a diversified pool of assets that might otherwise be inaccessible.

Here are some examples:

• Mortgage-Backed Securities (MBS)

  Imagine a large bank that has issued thousands of home mortgages to individual homeowners. Instead of keeping all these loans on its own books for decades, the bank can group many of these mortgages together into a large pool. It then creates and sells Mortgage-Backed Securities (MBS) to investors. These investors receive regular payments, which come directly from the principal and interest payments made by the homeowners on their original mortgages.

  How this illustrates the term: The individual home mortgages are the "assets" that back the "security." The value and payments of the MBS are entirely dependent on the performance of these pooled mortgages.

• Auto Loan-Backed Securities

  Consider a major auto finance company that provides loans to thousands of customers to purchase new and used cars. To manage its capital and lend more money, the company can gather a large number of these auto loans into a single pool. It then issues securities to investors, promising to pay them a portion of the principal and interest collected from the car buyers over time.

  How this illustrates the term: In this scenario, the individual auto loans are the "assets" that provide the cash flow and collateral for the "security." Investors are essentially buying a share of the future payments from these car loans.