Structured Finance

By: EconomyWatch Content   Date: 8 February 2010

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Structured finance is used by various financial institutions for companies with unique funding needs and when the conventional methods of lending are not feasible. This form of finance involves the creation of special legal and corporate entities to transfer risk as in the case of securitization. The use of interest rate swaps to lower a company’s borrowing costs is also a part of structured finance.

 

The use of structured finance has opened up new sources of financing for companies, while on the other hand resulting in the degradation of underwriting standards for financial assets. The high use of structured finance techniques was mainly responsible for the credit bubble of the mid-2000s and the financial crisis of 2007-2009.

Types of Structured Finance Instruments

Several types of instruments are issued by using structured finance techniques.

  • Asset Backed Securities or ABS: These are bonds or notes collateralized by the cash flows derived from a pool of underlying assets which could be mortgages, credit card receivables or loans.
  • Mortgage Backed Securities or MBS: These securities are backed by the principal and interest received from a set of mortgage loans. Collateralized Mortgage Obligations or CMOs are securitizations of mortgage backed securities.
  • Collateralized Debt Obligations or CDOs: This involves the consolidation of a group of assets, including ABS, and the issuance of securities in tranches with each tranche representing varying levels of risk. Collateralized Bond Obligations or CBOs are backed by corporate bonds, while Collateralized Loan Obligations or CLOs are backed by leveraged bank loans. CDOs backed by commercial real estate loans are called Commercial Real Estate Collateralized Debt Obligtions or CRE CDOs.
  • Credit Derivatives: These are contracts used to transfer the risk of return on a credit asset falling below an agreed level, without actually transferring the underlying asset.
  • Collateralized Fund Obligations or CFOs: They involve the securitization of private equity and hedge fund assets.

Motivation for using Structured Finance

The use of structured finance is ideal for companies not having much material assets but having a strong client base and a history of consistent cash flows. The use of structured finance also enables a company to lower its high interest liabilities and effectively exchanging them for lower interest and more manageable payments.

 


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