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Asset-backed Security Risk

An asset-backed security is a security backed by the cash that comes from numerous assets. The financial security is backed by student debt, leases, car loans, credit card debt, and more. Typically, the assets of an asset-backed security are not liquid and can't really be sold on their own. However securitization, is the process of pooling the assets together to create a security allows the owner of the assets to make them marketable. The creation of asset-backed securities start when lenders sell their collateralized loans to a large financial institution which then creates and places the loans into a trust. Cash flow then goes into the trust as the loans are being paid off while cash flows out as payments to the investors who bought the securities from that trust.

It has many advantages to both the lenders and investors. For example, it allows lenders to make a profit by increasing the lending and at the same time it encourages investors to invest their money into different assets that will benefit them. Lenders are able to create a pool of assets that would have resulted to be more challenging to trade individually. Asset-backed securities are fixed-income assets whose risk and return can be tailored to meet the needs of distinct investors.

The disadvantages of asset-backed securities are that they are as overvalued when compared to other security markets. Investors must take very high precautions when choosing which ABS to invest in. Also, asset-backed securities are susceptible to prepayment risks, interest rates, and term modification. For example, declining interest rates might prompt borrowers to refinance their loans at more favorable rates. Another disadvantage is if the borrower files bankruptcy, the loan could be lost to bankruptcy.

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