Asset-Backed Security (ABS)
Asset-Backed Security (ABS) is a security based on a pool of assets or secured by cash flows generated by assets.
• Transactions with asset-backed securities constitute off-balance securitization, where assets are written off from the balance sheet of the originating bank and transferred to the account of a special purpose vehicle (SPV), which issues securities; the source of payment for such securities is the proceeds from the transferred assets; the funds received by the originator are refinanced in the money or capital markets;
• Unlike Mortgage-Backed Securities (MBS), Asset-Backed Securities are secured by assets other than mortgage loans;
• The asset pool may include consumer credits, credit-card receivables, equipment lease payments, royalties and other expected cash flows;
• Securitized assets may be non-liquid and may have the private-use property;
• The credit rating of asset-backed securities may be higher than if the securities had been issued by the originating bank since they are cleared of any inherent risks, which makes these assets more attractive to investors.
Advantages for the originating bank:
• Liquidity enhancement by repacking assets: conversion of non-liquid assets into liquid that acquire value as an investment object;
• Additional source of financing;
• Reduction in value of borrowings;
• Effective risk sharing;
• Optimization of the originator’s balance management;
• Improvement of financial performance;
• Writing-off of a part of assets from the balance reduces the amount of risk weighted assets of the bank, which frees up the capital, providing an opportunity to issue even more loans.
Advantages for the investor:
• Investments in assets of the borrower if there is a possibility to choose a tranche with a suitable risk-return ratio;
• Diversification of assets that form the basis of the pool helps to reduce the risk of the security;
• Asset-backed securities are less exposed to price fluctuations as compared to corporate bonds;
• Yield on such securities is higher than on government bonds with comparable ratings;
• Diversification of the investor’s investment portfolio;
• Risk of default (credit risk);
• Interest risk related to the fact that the amount of interest payments generated by assets during the term of transaction will be lower than the interest paid on securities (e.g. when securities have a fixed interest rate and the assets have a floating interest rate, or vice versa);
• Risk of early redemption caused by early performance of obligations by borrowers and entailing a decrease in investment income, especially in conditions of interest rate decline:
• Currency risk that arises when assets are denominated and generate cash flows in a currency other than the currency in which the securities are denominated and paid;
• Difficulty for the investor to independently assess the credit risk of underlying assets;
• Legal complexity of transactions and the length of preparation.
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