ASSET BACKED SECURITIES (ABS), a financial innovation is a pool investment vehicle which was designed based on the collateral loans securitization. Securitization is a process by which financial assets like mortgages, car loans, account receivables are purchased by an entity which then issues securities to the investors supported by cashflows.
If anyone want to gain exposure in the bank’s mortgage loans traditionally one could invest into the bank’s fixed deposits, bank debt or common equity. Compared to the traditional structure securitization can provide more perks to the ABS investors.
Let’s us look at this from an example perspective,
There is a bank which gives housing loans on collateral. Instead of keeping those collaterals idle the bank will keep those collaterals in to a Special Purpose Vehicle (SPV). This SPV will securitize the collateral and issues the securities to the investors. The amount raised by the SPV through this issue will be given to the bank and therefore it can issue more loans. It reduces the financing cost of the firm selling financial assets to the special purpose entity.
BENEFITS OF SECURITIZATION:
- The securities issued by the ABS will have higher protection as they were backed by financial assets.
- The investor investing into ABS can get a better match with their preferred risk, return and maturity.
- The risk of the ABS are well diversified with tranches where senior tranches have low risk and junior tranches have high risk. The risk first hits the junior tranches and then passes to senior tranches.
- ABS provide liquidity to the firm issues them and the securities trades actively.
- Securitization provides diversification and risk reduction when compared with any other investment options.