Asset-backed securities (ABS) are created by buying and bundling loans – such as residential mortgage loans, commercial loans or student loans – and creating securities backed by those assets, which are then sold to investors. Often, a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities.
Consumer-related ABS are generally perceived to be safe assets because their short-duration makes cash flows more predictable, keeps ratings stable and puts them in a class of alternatives to cash and Treasuries. However, the 2008 credit crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets.
The Dodd-Frank Act, signed in 2010, imposed new requirements on ABS, including business conduct standards, credit risk retention and reporting.