 | ||
Structured finance is a sector of finance that was created to help transfer risk using complex legal and corporate entities. This transfer of risk, as applied to the securitization of various financial assets (mortgages, credit card receivables, auto loans, etc.), has helped provide increased liquidity or funding sources to markets like housing and to transfer risk to buyers of structured products; it also permits financial institutions to remove certain assets from their balance sheets as well as provides a means for investors to gain access to diversified asset classes. 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 2007–08.
Contents
Common examples of instruments created through securitization include collateralized debt obligations (CDOs) and asset-backed securities (ABS).
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.
The reasons for securitization are
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 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 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, like Moody's, Fitch or Standard & Poor's. 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.