The Advantages of Asset-Backed Securities

Banks create asset-backed securities as a result of a process called securitization. Assume that a bank is entitled to collect mortgage payments from 100 homeowners, resulting in monthly cash flows of $150,000. The bank may issue 100 bonds, which will now be entitled to receive most of the mortgage payments of these homeowners. As a result of this arrangement, the monthly mortgage payments will be passed on from the bank to the bond holders every month. Should a homeowner default and foreclosure ensue, the proceeds from the sale of the home will also be passed on to bond holders. This setup is known as asset-backed securitization, because the resulting securities, the bonds, are backed by the homes.

One way to distribute the monthly proceeds to bondholders is to pay every bondholder, say, $1,450 per month. The bank would keep $5,000 of the monthly income, with $145,000 going to bondholders. Should some homeowners default and foreclosures fail to cover the shortfall, each bondholder will share the loss equally.

However, there is another way to slice the pie. 50 Type A bonds may be paid, for instance, $1,200 monthly, while 50 Type B bonds receive $1,700. The upside to owning the first type of bond is that all losses up to a certain amount (let's say $50,000) are shouldered by the second class of bonds. If total monthly proceeds, after the bank takes a cut, are only $115,000 (due to homeowners defaulting on their mortgages), Type A bonds would still be paid their full $1,200. The remaining $55,000 would be divided among 50 Type Bs, which get $1,100 each.

The single greatest advantage of asset-backed securities is that the investor can adjust her risk exposure and return profile by selecting the appropriate type of bond. While a conservative investor might go for a Type A bond and receive only $1,200 per month, another investor can buy a Type B bond with the hope of receiving $1,700 on at least most months.

Asset-backed securities also allow the investor to bet on specific sectors in the economy. In addition to mortgage payments, proceeds from car loans, equipment leases and several other kinds of debt are pooled into asset-backed securities. If you expect a certain kind of loan to have a very low default ratio over the coming years, you can purchase a high-yielding but risky bond backed by that specific kind of loan.

Another significant advantage of asset-backed securities is that you do not have to worry about the risk profile of the bank that has bundled up a bunch of loans to create the specific bond you have bought. Even if the bank (or, in financial lingo, the intermediary), were to go bankrupt, your income stream will be unaffected. The money you receive comes from the loan payments of a large number of borrowers and not out of the pocket of the bank that issued the bond. Hence, asset-backed securities do not expose you to the risk profile of an intermediary.