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Structured finance is a sector of
finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, in the left corn ...

finance
- specifically
financial law Financial law is the law and regulation of the insurance, derivatives, commercial banking, capital markets and investment management sectors. Understanding Financial law is crucial to appreciating the creation and formation of banking A ba ...
- that manages
leverage Leverage or leveraged may refer to: *Leverage (mechanics), mechanical advantage achieved by using a lever *Leverage (album), ''Leverage'' (album), a 2012 album by Lyriel *Leverage (dance), a type of dance connection *Leverage (finance), using giv ...
and
risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty Uncertainty refers to Epistemology, epistemic situations involving imperfect or unknown information. It applies to predictions of future events, to ...
. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments. Securitization provides $15.6 trillion in financing and funded more than 50% of U.S. household debt last year. At the end of the day, through securitization and structured finance, more families, individuals, and businesses have access to essential credit, seamlessly and at a lower price. With more than 370 member institutions, the Structured Finance Association (SFA) is the leading trade association for the structured finance industry. SFA’s purpose is to help its members and public policymakers grow credit availability and the real economy in a responsible manner. ISDA conducted market surveys of its Primary Membership to provide a summary of the notional amount outstanding of interest rate, credit, and equity derivatives, until 2010. The ISD
Margin Survey
is also conducted annually to examine the state of collateral use and management among derivatives dealers and end-users
End-User Surveys
are also conducted to collect information on usage of privately negotiated derivatives.


Structure


Securitization

Structured finance utilizes
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 (or other non-debt assets which generate receivables) and selling ...
to pool assets, creating novel financial instruments to enable better use of available capital or serve as a cheaper source of funding, especially for lower-rated originators Other uses include alternative funding (ture), reducing credit concentration and for risk transfer and risk management interest rates and liquidity.


Tranching

Tranching refers to the creation of different classes of securities (typically with different credit ratings) from the same pool of assets. It is an important concept, because it is the system used to create different investment classes for the securities. Tranching allows the cash flow from the underlying asset to be diverted to various investor groups. The
Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution An international financial institution (IFI) is a financial institution that has been established (or chartered) by more than one country, and hence is subject ...

Bank for International Settlements
Committee on the Global Financial System explains tranching as follows: "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 Credit enhancement is the improvement of the credit profile of a structured financial transaction or the methods used to improve the credit profiles of such products or transactions. It is a key part of the securitization transaction Securitiza ...
is key in creating a security that has a higher rating than the underlying asset pool. Credit enhancement can be created, for example, 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. As a result, it is possible for defaults to occur in repayment of the underlying assets without affecting payments to holders of the senior bonds. Also, many deals, typically those involving riskier collateral, such as subprime and Alt-A mortgages, use over-collateralization as well as subordination. In over-collateralization, the balance of the underlying assets (e.g., loans) is greater than the balance of the bonds, thus creating excess interest in the deal which acts as a "cushion" against reduction in value of the underlying assets. Excess interest can be used to offset collateral losses before losses are allocated to bondholders, thus providing another credit enhancement. A further credit enhancement involves the use of derivatives such as swap transactions, which effectively provide insurance, for a set fee, against a decrease in value. Monoline insurers play a critical role in modern-day Credit Enhancements; they are more effective in (a) off-balance-sheet models creating synthetic collateral, (b) sovereign ratings' enhancement with built-in asset derivatives and (c) cross border loans with receivables and counterparties in the domain and jurisdiction of the monoline insurer. The decision whether to use a monoline insurer or not often depends upon the cost of such cover vis-a-vis the improvement in pricing for the loan or bond issue by virtue of such credit enhancement. Ratings play an important role in structured finance for instruments that are meant to be sold to investors. Many mutual funds, governments, and private investors only buy instruments that have been rated by a known
credit rating agency A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratingA credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their a ...
, like
Moody's Moody's Investors Service, often referred to as Moody's, is the bond credit rating In investment To invest is to allocate money Image:National-Debt-Gillray.jpeg, In a 1786 James Gillray caricature, the plentiful money bags handed to Kin ...
, Fitch or
S&P Global Ratings S&P Global Ratings (previously Standard & Poor's and informally known as S&P) is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, Bond (finance), bonds, and commodity, ...
. New rules in the U.S. and Europe have tightened the requirements for ratings agencies.


Types

There are several main types of structured finance instruments. * Asset-backed securities are bonds or notes based on pools of assets or collateralized by the cash flows from a specific pool of underlying assets. *
Mortgage-backed securities A mortgage-backed security (MBS) is a type of asset-backed security (an Financial instrument, 'instrument') which is secured by a mortgage loan, mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a ...
are asset-backed securities, the cash flows from which are backed by the principal and interest payments of a set of mortgage loans. ** Residential mortgage-backed securities deal with residential homes, usually single family. ** Commercial mortgage-backed securities are for commercial real estate, such as malls or office complexes. **
Collateralized mortgage obligation A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor needs ...
s are securitizations of mortgage-backed securities, typically involving multiple classes with differing levels of seniority. *
Collateralized debt obligation A collateralized debt obligation (CDO) is a type of structured finance, structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing Mortgage-backed se ...
s consolidate a group of fixed-income assets, such as
high-yield debt In finance Finance is a term for the management, creation, and study of money In a 1786 James Gillray caricature, the plentiful money bags handed to King George III are contrasted with the beggar whose legs and arms were amputated, i ...
or asset-backed securities, into a pool, which is then divided into various tranches. Many CDOs are collateralized by various types of mortgage-backed securities and other mortgage-related assets. An extension of these CDOs are "synthetic" CDOs which are collateralized by credit default swaps and other derivatives.Lemke, Lins and Picard, ''Mortgage-Backed Securities'', §5:17 (Thomson West, 2014 ed.). ** Collateralized bond obligations are collateralized debt obligations backed primarily by corporate bonds. **
Collateralized loan obligation Collateralized loan obligations (CLOs) 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. A CLO is a type of collat ...
s are collateralized debt obligations backed primarily by bank loans. ** Commercial real estate collateralized debt obligations are collateralized debt obligations backed primarily by commercial real estate loans and bonds. *
Credit derivativeIn finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money available w ...
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 obligation A collateralized fund obligation (CFO) is a form of securitization involving private equity fund or hedge fund assets, similar to collateralized debt obligations. CFOs are a Structured finance, structured form of financing for diversified private ...
s are securitizations of
private equity Private equity (PE) typically refers to investment funds, generally organized as limited partnerships, that buy and restructure companies that are not publicly traded. Private equity is a type of equity and one of the asset classes consisti ...
and
hedge fund A hedge fund is a pooled investment fund Image:Financial info.jpg, The values and performance of collective funds are listed in newspapers. An investment fund is a way of investment, investing money alongside other investors in order to benefit ...
assets. * Insurance linked securities are risk transfer instruments linked to insurance losses due to catastrophic events, which are generally seen as uncorrelated to traditional financial markets. *Partial guaranteed structures *Future flow transactions *Loan sell offs *Revolving Credit Financing (property or traded goods)


See also

*
Pooled investment An investment fund is a way of investment, investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These ad ...
*
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 (or other non-debt assets which generate receivables) and selling ...
*
Thomson Financial League Tables Refinitiv is an American-British global provider of financial market data and infrastructure. The company was founded in 2018. It is a subsidiary of London Stock Exchange Group after a US$27 billion dollar sale from previous owners Blackstone Gr ...
*
Structuring Structuring, also known as smurfing in banking A bank is a financial institution Financial institutions, otherwise known as banking institutions, are corporation A corporation is an organization—usually a group of people o ...

Structuring


References


External links


Jobst, Andreas A. (2007). "A Primer on Structured Finance" ''Journal of Derivatives and Hedge Funds''
*[https://web.archive.org/web/20040803153059/http://www.thestreet.com/pf/markets/matthewgoldstein/10174866.html Goldstein, Matthew (2004). "Post-Enron, Structured Finance Addiction Hasn't Ebbed" ''TheStreet.com'']
Andy, (2016). "Working capital is a company’s current assets minus its current liabilities" ''structurefunding.com''The Economics of Structured Finance
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