BackDe-jargoned: Asset-backed securities
It is an instrument created by securitizing loans
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In an attempt to stimulate economic activity and avoid the risk of deflation, the European Central Bank (ECB) on Thursday unexpectedly reduced interest rates. The ECB also announced that it will buy asset-backed securities (ABSs) from the marketplace to improve credit conditions in the single currency zone. Mario Draghi, president of ECB, in his opening remarks at a press conference on 4 September, said “The Eurosystem will purchase a broad portfolio of simple and transparent ABSs with underlying assets consisting of claims against the euro area non-financial private sector under an ABS purchase programme. This reflects the role of the ABS market in facilitating new credit flows to the economy…."
What is it?
ABS is an instrument created by securitizing loans such as credit cards, mortgages and for automobiles. Securitization is a process of pooling assets and selling the cash flows to a different set of investors. The Dodd-Frank Wall Street Reform and Consumer Protection Act (popularly known as the Dodd-Frank Act), passed by the US Congress in 2010, defined ABS as “a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset…."
ABSs are often evaluated and rated by credit rating agencies. These instruments have there positives and negatives. While the process of securitization and creation of ABS helps the lending institution maintain a lighter balance sheet, it also distributes the risk among different investors and is not concentrated on the books of the lender. However, since banks are aware that they will not be holding the asset on their balance sheet, they might become complacent while lending. This is exactly what led to the financial crisis of 2008. Simply put, banks and lending institutions in the US and other parts of the developed world were giving housing loans to people who had no or little ability to repay. These loans were packaged and sold to different investors around the world with high credit ratings. However, once the real estate prices started falling, the entire financial system began to fall like a pack of cards.
The ECB plan
The initial market reaction to the announcement has been positive but concerns remain. To make a meaningful difference, the ECB will have to buy ABSs in large quantities, but the availability is low. The ABS market in the region is estimated to be at around €1 trillion, but all of it may not qualify to be bought by the central bank.
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