The European Central Bank plans to start buying a type of bonds known as asset-backed securities. The move is aimed at spurring bank lending to companies and getting a slack economy moving again.
Here’s how asset-backed securities, or ABS, work and how buying them could help the economy.
— Asset-backed securities are created when banks bundle together a number of individual loans in the form of bonds. For instance, the bank makes many loans to companies or to people buying homes. The bank then creates a separate company, which buys the loans from the bank.
— The separate company — called a special purpose vehicle, or SPV, in investment jargon — then sells bonds to investors. It uses the cash it receives from the loans — the payments of principal and interest by the borrowers — to pay off the bonds.
— When the loans are sold to the SPV, the bank that originally made them gets cash that it can lend again.
— The ECB hopes that buying such bonds will stimulate the market for creating them. In other words, it will give banks another reason to make the underlying loans. That would mean more credit available for companies to expand their business and hire people.
— ABS got a bad reputation during the 2007-2009 subprime mortgage crisis in the U.S. Mortgage lenders packaged very shaky loans into highly complex versions of ABS that obscured how risky they really were. Purchasers, including other banks, were stuck with heavy losses.
— The ECB says it will only buy the simpler and highest-rated kinds of asset-backed securities. The ECB can buy some lower rated ones only if governments guarantee them.
— Even if banks are willing to make more loans, the end effect of the purchase program will still depend greatly on whether companies are willing to risk borrowing.
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