ABS in the “machine” of the economy

A brief introduction to Asset-Backed Securities

Today we will talk about ABS. Of course, we will not talk about the Anti-lock Braking System, that concerns the automotive world. Instead we will talk about Asset-Backed Securities.

These type of investment are still heavily accused by some journalists and economists to be one of the reasons of the 2008 financial crisis.

Thanks to the work of central banks, that purchased these financial instruments, ABS are now back to popularity. It is important to say that they are dangerous if only they are used in the wrong manner.

At this point, we have to ask ourselves a question: is it right to accuse an instrument just because it was used in the wrong way by humanity? The answer is, of course, negative.

 A deeper insight into ABS

The Asset-Backed Securities are derivatives; in other words, they are financial instruments whose value depends on a specific underlying asset. Talking about ABS, the underlying assets are loans lent from banks to specific categories of clients, both individuals and firms.

The assets that fall into ABS are illiquid so, if taken individually, they are unable to be sold on the market. Vice versa, if pooled together by subjects called originators (owners of loan portfolios or other assets) these financial instruments can be given to a Special Purpose Vehicle (SPV). This new entity, creates and sells the securities. The earnings will, finally, be used to pay the originators (typically banks or other financial institutions). This process is known as securitization.

It is easy to understand that, as long as ABS are backed by reliable loans, the whole system can be considered efficient. Through these derivatives, in fact, is possible to find new resources to invest. ABS could also help to lighten the balance sheets of the banks from low quality loans.

Vice versa, with insolvent subjects financed by ABS structures, retail investors are those who will face the worst conseguences. This way, an instrument that was created for good purposes is used in a terrible way.