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An asset-backed security (ABS) is a debt security collateralized by a pool of assets. An ABS is just like a mortgage-backed security, but the assets in an ABS are something other than a mortgage.  The types of assets can be auto loans, credit card debt, student loans, royalties, and even loans relating to solar energy purchases.

Often, the ABS is administered by a special-purpose entity that owns the assets and receives the creditors’ payments, then passes those payments on to the ABS’s various investors.

Typically, a financial institution, especially a bank, will bundle its loans into an ABS in order to remove risky loans from its balance sheet. Loans are bundled according to class and the credit ratings of the debtors.  Investors purchase the different ABSs based on their risk preferences. 

By bundling loans into ABSs, the bank receives two benefits:  reduced risk and an influx of cash, which the bank can then use to make additional loans.

Small Bank has 100 auto loans in its loan portfolio.  The total balance of these auto loans is $1 million.  The average interest rate on the loans is 12%.  Small Bank bundles all these loans into an ABS and sells it to an investor.  The credit rating of most of the debtors on these auto loans is very low, so there is a high risk of default. Because of this, the investor is not going to pay $1 million for Small Bank’s ABS.  Instead, Small Bank will sell it at a discount. 

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