What are asset-backed securities

Say a financial company takes an illiquid asset, like a loan or mortgage, and engineers it into something that can be easily sold in the form of a share or security. This is called securitisation.

A typical example is the mortgage-backed security. Let’s look at that a little more closely.

In this example, Omega Investments has purchased a number of mortgages from the loan book of Beta Bank. These mortgages are a mixture of differing quality: there are large loans to high net worth borrowers, all the way down to smaller loans to riskier borrowers.

Omega Investments arranges these into tranches of similar loan quality and then breaks each tranche down into shares that it can sell to investors, who receive payments (yield) at regular intervals as the mortgages are repaid by borrowers.

The tranches receive ratings from the rating agencies. Yield on the highest quality, senior secured tranches, will be less than that paid on unsecured tranches. This reflects the lower risk of borrowers defaulting on their mortgages.

Mortgage-backed securities come in two varieties: those backed by residential mortgages (RMBS) and those backed by commercial property (CMBS). Other types of loan can be securitised in similar ways – the most common of which is the collateralised loan obligation (CLO). 

The minimum investment amount for these types of securities is about $10,000, so it is more common for retail investors to gain exposure to this market through a fund.

Who wins?

There is a risk with most securities, and asset-backed vehicles are no exception. Remember that poorly packaged mortgage-backed securities ignited the last global financial crisis (2006-2008).

In a stable property market, the mortgage originators – who issued the original loans – may make a profit by selling on loans, which helps to de-risk their own balance sheets. 

Those who securitise the loans can also profit in certain circumstances. They also provide more capital for housing by supplying a measure of liquidity to the market – through their appetite for further loan securitisations. 

Investors may profit from regular payments while they hold an MBS, though they can buy and sell these securities at any point. Let's not forget, though, that the price they sell can vary hugely (depending on the market conditions at the point of sale). 

Bear in mind too that unexpected changes in interest rates, statements from central bankers or political events can hit mortgage-backed securities in any jurisdiction. Their specialist nature also adds to their volatility and price risk.