Definition of 'Asset-Backed Security'

Asset-backed securities allow companies to convert future cash flows, such as payments from customers, into money they can use right now. Investors who buy asset-backed securities then get the right to collect those future cash flows. These securities provide steady income to investors -- as long as the payments come in as expected.

How They Work

Say an auto finance company has $1 billion worth of outstanding loans that borrowers will be repaying over the next five to six years. The company could simply wait six years to collect all its money, or it could sell the rights to collect those payments to someone else. So the company sells bonds to investors. The money to pay off those bonds comes from the borrowers' future car payments. Those bonds are therefore asset-backed securities. Unlike typical corporate bonds, they aren't just backed up by the company's promise to pay; they're backed up by an asset -- the payments that the company is due to receive.

Types

The first asset-backed securities emerged from the mortgage industry, where outstanding loan amounts are large, and borrowers have decades to pay off. The financial services industry generally draws a distinction between "mortgage-backed securities" and "asset-backed securities." But in reality, a mortgage-backed security is just a particular type of ABS. The most common types of non-mortgage asset-backed securities involve payments on home equity loans, car loans, student loans, mobile-home loans and credit cards. But companies really can "securitize" just about any future stream of payments.

Bundling

Companies typically don't actually securitize their assets themselves. Instead, they sell them to third parties who do it. Mortgage lenders, for example, sell their loans to "bundlers" that turn them into bonds. The biggest bundlers by far are Fannie Mae and Freddie Mac, government-backed enterprises that exist to provide liquidity for lenders, allowing them to "cash in" their mortgages and use the money to make new loans. Some firms set up subsidiaries or even entirely separate companies to handle securitization on their behalf.

Risks

An asset-backed security is only as good as the payments that underlie it. If those payments don't get made -- if homeowners or car buyers or credit-card users default on their debts -- then the ABS loses value. If default is widespread enough, the ABS becomes worthless. The financial crisis of 2008 was touched off by skyrocketing mortgage defaults, which left financial institutions and investors holding hundreds of billions of dollars worth of bad securities. Defaults rose sharply because lenders had made so many bad loans -- and they made those loans to satisfy demand for mortgage-backed securities, which at the time were seen as safe investments.

Ratings

Credit rating agencies such as Standard & Poor's, Moody's and Fitch issue ratings for asset-backed securities just as they do for corporate bonds. The higher the rating on an MBS or ABS, the lower the perceived default risk. However, investors should keep in mind that ratings are subjective. Reporting in the wake of the 2008 financial crisis revealed that many of the mortgage-backed securities that went bad had received high ratings because the ratings agencies greatly miscalculated the likelihood that so many homeowners in all areas of the country would default at the same time.