Definition: Asset-backed securities

External debt - IMF

Asset-backed securities are bonds whose income payments and principal repayments are dependent on a pool of assets. Securities may be backed by various assets—for example, mortgages, credit card loans, automobile loans—in effect, converting illiquid assets into tradable securities. An asset-backed security enables the original lending institution to devolve credit risks to investors. There are several key features of asset-backed securities: the original lender will usually sell the assets to a trust or other form of intermediary (special purchase vehicle) and so, in the case of a bank, this frees "capital" that regulatory guidelines require a bank to hold against the assets. The intermediary will finance the purchase of the assets by issuing securities. Because income and the repayment of principal are dependent on the underlying assets, if the underlying assets are prepaid so is the security. Issuers often provide different tranches of the security so that if there are prepayments, the first tier will be repaid first, the second tier next, etc. The pricing of the various tranches will reflect the probability of early repayment. Asset-backed securities have also been developed that securitize future income streams—such as the earnings of musicians.