Asset-backed securities are bonds that are based on underlying pools of assets. A special purpose trust or instrument is set up which takes title to the assets and the cash flows are "passed through" to the investors in the form of an asset-backed security. The types of assets that can be "securitized" range from residential mortgages to credit card receivables.
All asset-backed securities are securities which are based on pools of underlying assets. These assets are usually illiquid and private in nature. A securitization occurs to make these assets available for investment to a much broader range of investors. The "pooling" of assets occurs to make the securitization large enough to be economical and to diversify the qualities of the underlying assets.
Residential mortgages, for example, provide some insight into the development of the asset-backed securities market. Before the development of the mortgage-backed securities market in the early 1980s, each residential mortgage underwritten was a unique transaction. Joe Q. Public would walk into his bank or trust company and enter into a mortgage. By way of example, Joe chooses Lack Trust Company. Joe enters into a mortgage on a specific real estate property, 100 Easy Street in the Hills of Richmond, with the good people of Lack Trust. Sounds easy. But think of what has to happen for this mortgage to be underwritten. Lack Trust must check Joe's credit (salary, assets, etc.) and establish the worth of the property through an appraisal. Joe and Lack Trust then negotiate and establish the terms. This includes the amount and interest rate of the mortgage, the amortization of principal, as well as the prepayment terms. Lack Trust then has to hire a lawyer to register the mortgage against the property with a property registry office.
It can easily be seen that Joe's mortgage is an unique thing. There are no other mortgages on 100 Easy Street with Joe as the borrower on those terms and conditions. That is why most mortgages were held by the financial company that originated them. Trading was awkward, as the mortgages had to each be evaluated and administered differently. The originating organization usually kept the servicing and were loath to part with their mortgages. Only very large institutional investors participated in this market. Smaller investors did not have the expertise to evaluate the mortgages, or a large enough portfolio to properly diversify. If a single mortgage was in the $200,000 range, a maximum 10% position would require a total portfolio of over $2,000,000 to be properly diversified. Therefore, for an individual investor, if their portfolio was to be properly diversified, a mortgage was an awkward asset to own.
If we combine Joe and five hundred other borrowers in a mortgage "pool" we have something that is bigger, which makes it more economical to issue, and better in credit quality, because of the diversification from the large number of mortgages. In a total pool of $100 million, no one mortgage of $200,000 is more 5% and not a large enough part of the pool to "skew" the pool's characteristics in any one aspect. If, for example, Easy Street turns out to be the site of a former radium factory, the fact Joe's house is worth less than we expected is not a fatal issue for the pool of assets as a whole.
Administration of the pool of mortgages is more systematic as well. We can have the same "servicing agent" collect all the monies from all the mortgages and "pass it through" to the investors via a central trustee. We can have the payments made to the investors at the same date each month. We can even supply aggregate data and statistics on the pool to investors, such as the "Weighted Average Coupon" (WAC), or "Remaining Amortization" (RAM).
One can now see that this unruly mass of mortgages is starting to look pretty much like a boring old bond to an investor. One payment from one source, once a month. Combined with a "book-based" custody system, we have now made a source of cash flows that "walks and talks like a bond". Not bad for something that used to be a lump of unique assets.
The wonder of securization is that it takes a wide variety of formerly illiquid and directly held assets and makes them available to many investors in the form of asset-backed securities. This simple process can be applied to all sorts of cash flow producing assets. If a retailer needs cash, it securitizes part of its outstanding credit card balances from its customers into a "credit card receivables trust". An auto leasing firm takes the outstanding automobile lease balances and turns them into an "auto receivables trust". A bank takes a group of its higher quality customers and creates an "evergreen revolving financing trust" which constantly takes high quality receivables and finances them by issuing bonds from the trust.