The Advantages of Asset-Backed Securities
An asset-backed security is an investment created by pooling together underlying assets and selling them on the open market. For example, auto finance companies pool together loans to car owners and issue securities using those loans as collateral. The poorer the credit history of the borrower, the greater the return on the security, but also the greater risk.
Other People Are Reading
-
Ease of Trade
-
One advantage of asset-backed securities for buyers and sellers is the ability to trade in assets that would otherwise be difficult to market. For example, one investor would be unlikely to simply take on a car loan held by an auto finance company because of the risk and complexity of such an investment for an individual. However, if hundreds or thousands of car loans are aggregated and divided up into smaller securities, an investor may be more willing to invest in that market.
Risk Sharing
-
Another advantage, particularly for buyers, is the ability to spread risk over a number of investors. Consider, for example, a market for home mortgages. As discussed above, the risk for any one investor may be too great to take on such an investment because that mortgage holder may default, leaving the investor with nothing. However, if a number of mortgages are pooled and then divided, no one investor bears the risk of an entire mortgage, and it is far less likely that every mortgage holder in the pool will default.
-
Increased Loans for Borrowers
-
For borrowers, asset-backed securities increase the availability of loans. A large mortgage bank may only be able to lend a total of $500 million based on its required reserve ratio and maximum level of risk-weighted assets. However, if this bank is able to pool $200 million of its loans and sell them as securities, it has that much more money to loan to other borrowers because the market has essentially provided extra capital for the bank.
Regulatory Issues
-
Most financial institutions must comply with a variety of government regulations surrounding the issuing of credit and the number of loans they are able to have on their balance sheets. Because many financial institutions use organizations known as conduits to securitize their assets and sell them to investors, the financial institutions are able to move those assets off their books and more easily comply with government regulations.
-
References
- Photo Credit Thinkstock/Comstock/Getty Images
