Asset-backed securities (ABS) and mortgage-backed securities (MBS) explained

Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.
Both Asset-backed securities (ABS) and mortgage-backed securities (MBS) are fixed-income financial securities collateralized (backed) by a pool of assets such as Auto loans, Education Loans, Housing loans, credit card debts, and receivables, etc. This pool of assets is characteristically a group of small and illiquid assets that are unable to be sold individually. Mortgage Based Securities (MBS) are also a type of asset-based securities (ABS), but they are generally distinguished as the pooling of mortgage assets (MBS) and non-mortgage assets (ABS). In other words, the MBS are created from the pooling of mortgages that are sold to interested investors, whereas an ABS is similar to a mortgage-backed security, except that the underlying securities are not mortgage-based.

The structure of ABS and MBS types of securities are the same viz. (i) the seller, (ii) the issuer, and (iii) the investors.

Seller:  Sellers are the banks and financial institutions that generate loans and debts, and later sell their assets (loans and debts) to issuers. Under the sale, the seller acts as the servicer to the issuer, i.e. collecting principal and interest payments from the seller’s borrowers at regular intervals and transmitting such regular collection to the issuer. The banks and financial institutions benefit from selling ABS and MBS because these illiquid assets can be removed from their balance sheet, in exchange for fresh funds available for further lending. This process can be used to reduce the bank’s exposure to a particular type of loan portfolio/s.

Issuer: The issuer is the trust or a legal entity that repackages the loans purchased by it as interest-bearing securities and issues them to public investors.

Investors:  Investors of ABS and MBS are typically institutional investors. These investors buy ABS and MBS in an attempt to obtain higher yields than government bonds and provide diversification of their investments.

The assets that are used to create ABS or MBS are called securitized assets and the cash flow generated by ABS or MBS are called collateral.

The creation of ABS or MBS involves transferring ownership of assets (loans, debts etc.) from the banks or financial institution generally to a special-purpose vehicle (SPV), whose sole function is to buy such assets to securitize them. The SPV, which is usually a corporation, then sells them to a trust. Sometimes banks may directly sell their assets to a Trust without the intervention of SPV. The trust repackages the loans as interest-bearing securities similar to bonds in the open market. For investors, ABS/ MBS, are much like bonds that offer monthly, quarterly, or half-yearly income along with the principal.

How it works?

Suppose a borrower of XYZ bank repays the loan amount in Equated Monthly Installments. The XYZ bank which had already sold the above loan to the issuer keeps its fee or spread and sends the balance amount to the issuer. The issuer in turn keeps its margin and distributes the interest payment and principal to the investors in a similar way that the payments made by a company to its bond holders.

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