When investors invest in companies, they are issued a “security” to represent the money they have invested. The most common forms of securities are stocks, bonds, mutual funds and exchange traded funds (ETFs).
An asset-backed security (ABS) is just another type of security, but it is different in the following ways:
- It is developed and sold on behalf of finance companies (lenders).
- The process includes: Pooling the assets of the finance companies (the individual loans, leases and credit card debts they have extended to their customers), securitizing them (the process of converting them into investable securities) and then selling them to investors.
- These securities are backed by the assets–accounts receivables, inventories, royalties–of the borrowers behind the individual loans.
- The lenders use the capital raised by selling these securities to lend out more money to more borrowers.
More about asset-backed securities
The individual loans that underlie an ABS are typically illiquid and can't be sold on their own. However, once pooled and securitized, they become liquid and are freely traded in the open markets. The income that flows from the payments on the underlying loans is then used to compensate the holders of the securities.
Securities that are backed by real estate are called mortgage-backed securities (MBS), not asset-backed securities.