Asset backed securities (ABS)
What are they?
Asset backed securities are bonds which are backed by an asset, or by lots of assets.
How do they differ from normal bonds? Well... in the normal scenario a company that wants to raise $100 might issue 100 bonds to investors with a face value of $1. Every year it might pay those investors $0.05 in interest for each bond they hold, and that money will come from an unspecified source (eg, its revenues).
Under an asset backed bond, the money generated by the assets that are being used to back the bond will pay the interest. Those assets might be anything from buildings (in which case the interest might be paid from rent) to credit cards payments, mortgages, or car loans.
Why are credit cards, mortgages or car loans an asset? Well...let's say you take out a $20k loan to buy a car and you agree to pay back $800 per month for the next few years - the fact that you've committed to pay that money back creates a 'guaranteed' future cash flow, and this can be seen as an asset. Based on that future cash flow, it's possible to create a bond which will pay interest out of the money you're paying to service your car loan. Needless to say, ABS aren't based on one single person's loan, but lots of people's pooled together.
What have they got to do with the financial crisis?
ABS are based on the concept of securitization, and securitization is blamed for the lax lending standards which encouraged US banks in particular to lend money to people who'd never be able to pay it back.
The kinds of asset backed securities which have caused problems for the credit crunch are, in particular, mortgaged backed securities.
CDOs, which are a more complex version of standard ABS, are also at the heart of the crunch. The complexity of CDOs means investors often don't know which assets are involved in them, let alone what they're worth.
Useful Links:
$747 million worth of ABS issuance in the U.K in first six months of 2009, compared with $9 billion in the same period of 2008. (Wall Street Journal )
Last updated on 26 July 2009.
