Structured finance
Encyclopedia
Structured finance is a broad term used to describe a sector of finance
that was created to help transfer risk
and avoid laws
Structured finance is a broad term used to describe a sector of finance
that was created to help transfer risk
and avoid laws
Structured finance is a broad term used to describe a sector of finance
that was created to help transfer risk
and avoid lawsJanet Tavakoli
, Structured finance and collateralized debt obligations, 2008, 2nd ed using complex legal and corporate entities. This risk transfer as applied to securitization
of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However, it arguably contributed to the degradation in underwriting standards for these financial assets, which helped give rise to both the inflationary credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.
Tranching allows the cash flow from the underlying asset to be diverted to the various investor groups.
The Committee on the Global Financial System explained tranching succinctly:
"A key goal of the tranching process is to create at least one class of securities whose rating is higher than the average rating of the underlying collateral pool or to create rated securities from a pool of unrated assets. This is accomplished through the use of credit support (enhancement), such as
prioritization of payments to the different tranches."
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
that was created to help transfer risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
and avoid laws
Structured finance is a broad term used to describe a sector of finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
that was created to help transfer risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
and avoid laws
Structured finance is a broad term used to describe a sector of finance
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
that was created to help transfer risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
and avoid lawsJanet Tavakoli
Janet Tavakoli
Janet Tavakoli is an American author and structured finance expert based in Chicago. She has had three books published on credit derivatives, structured finance, and the 2008 global financial crisis.-Education and background:...
, Structured finance and collateralized debt obligations, 2008, 2nd ed using complex legal and corporate entities. This risk transfer as applied to securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However, it arguably contributed to the degradation in underwriting standards for these financial assets, which helped give rise to both the inflationary credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.
Securitization
Securitization is the method utilized by participants of structured finance to create the pools of assets that are used in the creation of the end product financial instruments.Reasons for securitization
- Better utilization of the available capital
- Alternative funding
- Cheaper source of funding especially for lower rated originators
- Reducing credit concentration
- Risk management interest rates and liquidity
Tranching
Tranching is an important concept in structured finance because it is the system used to create different investment classes for the securities that are created in the structured finance world.Tranching allows the cash flow from the underlying asset to be diverted to the various investor groups.
The Committee on the Global Financial System explained tranching succinctly:
"A key goal of the tranching process is to create at least one class of securities whose rating is higher than the average rating of the underlying collateral pool or to create rated securities from a pool of unrated assets. This is accomplished through the use of credit support (enhancement), such as
prioritization of payments to the different tranches."
Credit enhancement
Credit enhancement is key in creating a security that has a higher rating than the issuing company. Credit enhancement can be created by issuing subordinate bonds. The subordinate bonds are allocated any losses from the collateral before losses are allocated to the senior bonds, thus giving senior bonds a credit enhancement. Also, many deals, typically deals involving riskier collateral such as subprime and Alt-A, use overcollateralization as well as subordination. In overcollaterization, the balance of the loans is greater than the balance of the bonds, thus creating excess interest in the deal. Excess interest can be used to offset collateral losses before losses are allocated to bondholders thus providing another added credit enhancement. Another credit enhancement involves the use of derivatives such as swap.Credit ratings
Ratings play an important role in structured finance.Other structures
There are numerous structures which may involve mezzanine risk participation, options and futures within structuring of financing as well as multiple stripping of interest rate strips. There is no laid-out fixed structure unlike in securitization which is only a subset of the overall structured transactions. Esoteric transactions often have multiple lenders and borrowers distributed by distribution agents where the structuring entity may not be involved in the transaction at all.Types
There are several main types of structured finance instruments.- Asset-backed securitiesAsset-backed securityAn asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
(ABS) are bonds or notes based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. - Mortgage-backed securitiesMortgage-backed securityA mortgage-backed security is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization.-Securitization:...
(MBS) are asset-backed securities the cash flows of which are backed by the principal and interest payments of a set of mortgage loans.- Residential Mortgage-Backed Securities, (RMBS) deal with Residential homes, usually single family.
- Commercial Mortgage-Backed Securities (CMBS) are for Commercial Real Estate such as malls or office complexes.
- Collateralized mortgage obligationCollateralized mortgage obligationA collateralized mortgage obligation is a type of financial debt vehicle that was first created in 1983 by the investment banks Salomon Brothers and First Boston for U.S. mortgage lender Freddie Mac. A collateralized mortgage obligation (CMO) is a type of financial debt vehicle that was first...
s (CMOs) are securitizations of mortgage-backed securities.
- Collateralized debt obligationCollateralized debt obligationCollateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...
s (CDOs) consolidate a group of fixed income assets such as high-yield debtHigh-yield debtIn finance, a high-yield bond is a bond that is rated below investment grade...
or asset-backed securities into a pool, which is then divided into various tranches.- Collateralized bond obligations (CBOs) are CDOs backed primarily by corporate bonds.
- Collateralized loan obligationCollateralized loan obligationCollateralized loan obligations are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches...
s (CLOs) are CDOs backed primarily by leveraged bank loans. - Commercial real estate collateralized debt obligations (CRE CDOs) are CDOs backed primarily by commercial real estate loans and bonds.
- Credit derivativeCredit derivativeIn finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
s are contracts to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset. - Collateralized fund obligationCollateralized Fund ObligationA collateralized fund obligation is a form of securitization involving private equity fund or hedge fund assets, similar to collateralized debt obligations...
s (CFOs) are securitizations of private equityPrivate equityPrivate equity, in finance, is an asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange....
and hedge fundHedge fundA hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
assets. - Partial Guaranteed Structures (PGS)
- Future Flow TRansactions (FFT)
- Loan Sell Offs (LSO)
See also
- Pooled investment
- SecuritizationSecuritizationSecuritization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
- Thomson Financial League Tables
- Structuring
External links
- Jobst, Andreas A. (2007). "A Primer on Structured Finance" Journal of Derivatives and Hedge Funds
- Tergesen, Anne (2006). "Structured Notes: Quirkiest Vehicle on the Street", Business Week
- Goldstein, Matthew (2004). "Post-Enron, Structured Finance Addiction Hasn't Ebbed" TheStreet.com
- The Economics of Structured Finance