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An asset-backed security is a security with a value which is secured by a pool of assets. These assets can include outstanding car loans, credit card debt, or student loans. Mortgage-backed securities could be considered a form of asset-backed security, but they are usually discussed separately. Like other securities, asset-backed securities can be bought, sold, and traded on the financial markets by people who utilize the movement of securities to generate an income.
Making asset-backed securities starts with a process known as securitization. The originating lender puts together a pool of assets, such as car loans, and then sells shares from the pool as securities. In some cases, the lender may use what is known as a special purpose vehicle, transferring the assets off their books and allowing the special purpose vehicle to handle the securitization and sale. The bank receives funds when the asset-backed securities are sold.
The idea behind an asset-backed security is that it diversifies risk. By creating a large pool of assets and securitizing them, lenders can reduce the risk created by losses within that pool. If one person fails to repay a student loan, for example, it will be swallowed up by the larger pool. Banks can also mix assets with various debt ratings, bundling poorly rated debt in with high rated debt in order to make the debt less risky. Using asset-backed securities also allows banks to create tradeable material out of assets which normally cannot be traded very easily.
One advantage to the sale of an asset-backed security offering is that it frees up a lender to make more loans, which keeps the credit market flowing. However, this can also be problematic, as lenders may not be as cautious about loans when they know that they will be packaged and securitized later. Rather than viewing individual loan risks, banks may look at overall trends, potentially creating bad loans.
The practice of creating asset-backed securities has been variably praised and criticized, depending on the economic market. It is important to distinguish between different types. Mortgage loans tend to make a more risky backing, for example, and mortgage-backed securities have been implicated in the 2008 financial crisis. On the other hand, assets such as car loans and student loans can be very reliable performers, generating stable income with relatively low risk. In all cases, however, liability tends to be transferred from the original lender with an asset-backed security, which can encourage reckless lending behavior.