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What is ABS?

Posted by Kelly Chung on January 7, 2009

Securitization is the transformation of an illiquid asset into a security.
Like, consumer loans(credit card debts) can be transformed into a publicly issued debt security (like corporate bonds). With credit enhancement in place, asset-backed securities (ABS) have became safe, liquid and high-yielding investments. For industrial, financial and other service sector companies capable of originating and servicing securitizable assets, ABS became a corporate finance alternative as equities, bonds and bank loans.
A lender originates loans, like homeowner or corporation. The bank or firm sells certain assets to the investors. Credit Agency (like Moody’s) reviews the company’s rating and credit enhancement.The credit agencies will update the rating based on the company inherent risks. Here are the factors agencies examine: – credit risk – liquidity risk – counterparty risk – legal risk – interest risk and currency risk – prepayment risk – cash flow structure

A financial guarantee (bond insurance) is used in ABS to enhance a security to the triple A level, based on the financial guarantee company’s triple-A rating. The guarantee is designed to ensure that investors will receive timely payments of principal and interest, regardless of whether the underlying collateral assets are able to support such payments.

Note: Credit enhancement means excess cash flow, third-party guarantees, Letters of credit, cash collateral accounts

AAA = High quality debt instruments, like US Treasury;   A = Strong to adequate ability to pay principal and interest;   B = Principal speculative;   D = Default

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