Asset-backed securities and Mortgage-backed securities are the asset classes that form a part of the fixed income segment. These securitized financial instruments played a crucial rule during Global Financial Crisis of 2008 which witnessed significant economic meltdown, property bubble collapse, crashing banking sector and sluggish growth across major world economies. Analysts often quote how Australian securitization market has resurrected from the global recession a decade back. It becomes imperative to understand these financial instruments.
Three parties play a role in these asset-backed securities and mortgage-backed securities: the sellers, the issuers and the investors. Sellers issue the loan and collect principle amount and the interest from the borrower. Issuers are those who buy loans from the sellers and club them together and release them as ABS or MBS. Institutional investors use ABS and MBS to get better and higher yields.
Asset-Backed security (ABS) is a security whose income payment, and value is derived through collateral which is a specified pool of underlying illiquid assets. These assets include credit card debt, loans, royalties or receivables, leases.
Through the asset-backed securities, the issuer of the loan amount will be able to generate more money in the form of cash which will enable them to lend the loan to other investors further. On the other hand, investors, through these asset-backed securities get an opportunity to take an exposure to diversified high-yield financial instruments. ABS being illiquid, the asset under ABS can be pooled to create financial security through the process of securitization which gives the owner of the asset, the power to make them marketable.
Financial institutions provide the loan to investors such as credit card providers, auto finance companies and consumer finance companies. These institutions now sell these loans to special purpose vehicle (also known as SPV) who pool these similar financial assets as collateral for securities. SPV then sell these assets to the trust which unbundles it and then make packages of interest-bearing securities and issues them.
Mortgage-backed securities (MBS) are just like asset-backed securities. However, the difference between the two is that underlying asset under asset-backed securities is not mortgaged based whereas a mortgage backs the underlying asset under Mortgage-backed securities, or we can also say it as a collection of mortgages. The security under mortgage should be such that it gives periodic payment equivalent to coupon payments. It should also be categorized under the list of the top two credit rating agencies.
Mortgage-backed securities are through either central government agency company or government-sponsored enterprise or any private financial company. There are two kinds of mortgage-backed securities namely Pass-through certificates and Collateralized Mortgage Obligations (CMO). In pass-through MBS’s, the mortgage payments that gets collected is passed through the investors. These have maturities of five years, 15 years and 30 years. In collateralized mortgage obligations, multiple pools of securities that are clubbed together and sold as an investment.
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