This blog will make an attempt to answer questions received from some of my MBA student-readers on structured finance.

What is structured finance?

Structured Finance enables efficient refinancing and hedging profitable economic activity beyond the scope of conventional form of on-balance sheet securities with a view to reduce cost of capital and to mitigate market impediments on liquidity. Essentially they are risk transfer instruments.

Structured finance instruments can be defined through three distinct characteristics: (1) pooling of assets (either cash-based or synthetically created); (2) delinking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through the transfer of the underlying assets to a finite-lived, standalone special purpose vehicle (SPV); and (3) tranching of liabilities that are backed by the asset pool. While the first two characteristics are also present with classical pass-through securitizations, the tranching of liabilities sets structured finance products apart

How it is structured?

Most structured finance products (i) combine traditional asset classes with contingent claims, such as risk transfer derivatives and/or derivative claims on commodities, currencies or receivables from other reference assets, or (ii) replicate traditional asset classes through synthetication

Who resorts to them?

Structured finance is invoked by financial and non-financial institutions in both banking and capital markets if established forms of external finance are either (i) unavailable (or depleted) for a particular financing need, or (ii) traditional sources of funds are too expensive for issuers to mobilize sufficient fund for what would otherwise be an unattractive investment based on the issuer’s desired cost of capital

What do they offer?

Structured finance offers the issuers enormous flexibility in terms of maturity structure, security design and asset types, which allows issuers to provide enhanced return at a customized degree of diversification commensurate to an individual investor’s appetite for risk

Structured finance contributes to a more complete capital market by offering any mean-variance trade-off along the efficient frontier of optimal diversification at lower transaction cost.

Structured finance facilitates breaking traditional financial instruments into their component risk and returns parts, them reassembling them to create more attractive instruments for issuers and investors. When done properly these transactions provide numerous benefits.

For the issuer, they lower issuers’ funding costs by removing inefficiencies in the capital markets, and they enhance issuers’ liquidity by diversifying their funding sources and enabling them to monetize assets that would be difficult to sell outright.

For investors, the principal benefit is flexibility. Investments can be tailored to fit the desired risk profile of an investor. Since structured finance enables them to take on exposures to many types of risk in the form of securities – usually investment grade – that can easily be sold in the secondary market. Investors too benefit from the increased liquidity. It also gives them the benefits of diversification by enabling them to take on exposure to aggregations of assets in ways that minimize risk.

The complexity of structured finance

Some of the sources of complexity in structured finance include pooling & tranching, non-default risks and structured finance ratings. Non-default risks include conflicts of interest, preservation of excess spread and performance of third parties.

Risks of structured finance

- Model risk

- Tranche risk

- Pool default risk

- Counter

Some Sample products in Structured Finance

- Traditional Products

o Credit insurance

o Syndicated loans

- Capital market products

o Structured finance products

§ Securitization

· Asset backed securities

· Mortgage backed securities

· Collateralized debt obligations

o Collateralized loan obligations

o Collateralized bond obligations

§ Pure credit derivatives

· Credit default swaps

· Total return swaps

· Credit spread options

· Recovery swaps

o Other instruments

- Hybrid products

o Regular hybrids

§ Credit linked notes

§ Synthetic CDOs

o Indexed hybrids

§ iTraxx/CDX correlation hedging and single tranche CDOs

o Pools of pools & leveraged hybrids

§ CDOs with structured finance collaterals e.g. CDOs of CDOs (of CDOs) and other securitized / structured products

§ CDS on specific CDO tranches

Structured Vs Traditional Finance

The flexible nature of structured finance straddles the indistinct boundary between traditional fixed income products, debentures and equity on one hand and derivative transactions on the other hand. A functional and substantive differentiation seems to be most instructive for guiding an informed demarcation between the most salient properties of structured and conventional forms of external finance.

I believe this structured insight into structured finance may be of some use!