Structured finance has become an increasingly popular way for companies and institutions to raise capital and manage risk. But for many, the world of structured finance remains mysterious and complex.
In this beginner’s guide, we’ll break down exactly what structured finance is, how it works, its benefits and risks, and the key players involved. Whether you’re an investor looking to diversify your portfolio or simply want to learn more about this intriguing financial tool, read on to get up to speed on structured finance.
Table of Contents
What is Structured Finance?
Structured finance refers to a sector of finance that involves pooling various types of assets or debts and then selling portions of that pooled product to investors. The pooled assets are sliced into sections called tranches, each with a different priority and risk level.
The goal of structured finance is for institutions to raise capital, reduce risk exposure, and offer customized investment products. Popular assets used in structured finance include residential and commercial mortgages, auto loans, credit card debt, student loans, and more.
Here are some key things to know about structured finance:
- Complex financial instruments are created by pooling assets and tranching risk
- Enables companies to raise capital and transfer risk
- Creates customized investment products to suit investor risk appetites
- Includes instruments like CDOs, CLOs, CMOs, and more
- Regulated by government agencies like the SEC
How Does Structured Finance Work?
There are many types of structured finance products, but most follow a similar basic mechanism. Here’s an overview of how structured finance typically works:
- Originator sources and bundles assets. This is the institution that originates or owns the assets, like a bank that offers mortgages or a lender that owns auto loan debt. The originator pools together these assets into a portfolio.
- Special Purpose Vehicle (SPV) purchases assets. An SPV is created solely for this securitization process. The SPV purchases the asset portfolio from the originator.
- SPV structures and tranches the assets. The SPV structures the pooled assets into tranches, or slices, with varying levels of risk and return. The top tranches are rated AAA to AA, the middle BBB to BB, and equity/first-loss tranches are unrated.
- SPV issues securities. The SPV issues securities representing the tranches. These securities give rights to the cash flows from the underlying asset pool.
- Securities sold to investors. The SPV sells the structured finance securities to investors. Conservative investors may opt for higher-rated tranches, while those seeking higher returns accept more risk.
- Mortgages/assets are serviced. The originator typically continues to service the assets. For example, collecting mortgage payments from homeowners and distributing them to the SPV.
- SPV makes payments. The cash flows from the assets are distributed by the SPV to investors according to the seniority and rating of their securities tranche.
- Assets mature or are sold. When the underlying assets mature or are sold, the capital is returned the SPV and then to investors accordingly.
- SPV closes. Once the assets mature and required investor payments are distributed, the SPV closes.
Key Benefits of Structured Finance
Structured finance offers several benefits, both to institutions structuring the products and investors purchasing securities:
- Access to capital – Enables institutions to raise capital by selling assets to an SPV
- Liquidity – Creates tradable securities, providing liquidity for assets like mortgages
- Customization – Can structure securities with varied risk, return, and cash flow profiles
- Risk transfer – Originators transfer assets off balance sheet and isolate risks
- Diversification – Allows investors to gain exposure to esoteric asset classes
- Higher yields – Structured products offer higher yields than similarly rated bonds
- Tailored risk-taking – Investors can choose tranches matching their risk appetite
Risks and Drawbacks
However, structured finance also comes with distinct risks and drawbacks:
- Complexity – Difficult for investors to fully understand risk and cash flow priority
- Lack of transparency – Details of underlying asset pools not always available
- Credit rating reliance – Ratings proved overly optimistic on some structured products
- Financial engineering – Risks may be underestimated or concentrated in lower tranches
- Volatile returns – Investor returns are linked to performance of underlying assets
- Liquidity risk – May have low liquidity and lack active secondary market trading
Noteworthy Structured Finance Products
There are various structured finance products created through securitization. Here are some major examples:
- Collateralized debt obligations (CDOs) – Repackaging of corporate debt and bonds
- Collateralized loan obligations (CLOs) – Securitization of bank loans to corporations
- Commercial mortgage-backed securities (CMBS) – Mortgages on commercial real estate properties
- Residential mortgage-backed securities (RMBS) – Mortgages on residential real estate properties
- Asset-backed securities (ABS) – Securitization of loans like auto, credit card, student debt
- Structured investment vehicles (SIVs) – Pool assets and use short-term debt to finance longer term assets
Major Players in Structured Finance
Several key institutions play important roles in the structured finance market:
- Investment banks – Help structure products, underwrite deals, and distribute securities
- Government sponsored enterprises (GSEs) – Major securitizers of mortgages through Fannie Mae and Freddie Mac
- Commercial banks – Originate and securitize assets through SPVs
- Institutional investors – Purchase structured finance products for income and diversification
- Rating agencies – Provide credit ratings evaluating risk levels of tranches
- Monoline insurers – Insure structured finance securities, especially higher risk tranches
- Law firms – Handle legal and regulatory complexity of securitization deals
- Accounting firms – Oversee proper accounting treatment and compliance
The Future of Structured Finance
Structured finance saw its reputation severely damaged following the 2008 financial crisis when overly complex products like CDOs amplified systemic risks. But the sector has recovered and remains an important part of global debt capital markets.
More transparency, simpler deal structures, improved risk assessment, and enhanced regulation have strengthened structured finance. The market is evolving with greater standardization and index-based products that allow more liquid trading. Future trends include:
- Rise of ETFs and indexed structured products
- Increased role of technology and automation
- Focus on quality underwriting and due diligence
- More balance sheet-friendly capital relief trades
- Expansion into new asset classes like royalties or cryptocurrency
- Growing global demand, led by Asia Pacific securitization markets
Structured finance introduces unique risks and complexities but also provides institutions and investors access to specialized investment opportunities. Understanding how structured finance works, its pros and cons, and recent trends can help you determine if and how these products may fit into your broader investment strategy.
Q&A on Structured Finance
Q: What are the main asset classes used in structured finance?
A: The most common asset classes securitized in structured finance include residential mortgages, commercial mortgages, auto loans, credit card receivables, student loans, equipment leases, and small business loans. Almost any asset that generates a predictable cash flow can be pooled and structured.
Q: What is an SPV and what is its purpose?
A: SPV stands for Special Purpose Vehicle. It is an entity created specifically for securitizing assets in structured finance deals. The SPV isolates the assets from the originator and establishes bankruptcy remoteness. It also simplifies administering the assets.
Q: How did structured finance contribute to the 2008 financial crisis?
A: Overly complex securitizations with inadequate risk assessment led to a crisis when the housing bubble burst. Subprime mortgages were packed into opaque, risky products that received AAA ratings. Investor losses led to market panic and contagion across the financial system.
Q: What are the risks to investors who buy structured finance products?
A: Investors take on risks including market risk, interest rate risk, liquidity risk, prepayment risk, and, depending on the tranche, varying levels of credit risk. The complexity also means products may harbor hidden risks. Lower tranches have higher default risk exposure.
Q: What are the main differences between CLOs and CDOs?
A: CLOs pool corporate loans while CDOs pool other credit like corporate bonds. CLOs are also more standardized and transparent. Since 2008, CLOs have performed more consistently than the broader structured finance market.