Structured Finance

What Is Structured Finance?

Structured finance is defined as a sophisticated means of financing through pooling loans backed by cash flow-generating assets into financial securities. Then, selling these securities in the capital market under the title of "tranches".

Structured finance focuses on financial lending tools that help to reduce risks associated with advanced and complex financial assets.

Companies with complicated funding requirements, often unsolvable with traditional financing, might use this finance as a tool.

This finance is typically not available from conventional lending institutions.

Structured finance controls risk and creates financial markets for complicated developing markets. It also helps retail investors invest their money directly in the market by not fully exposing the security. 

Structured finance tools, such as collateralized debt obligations and other structured financial instruments, cannot be transferred.

Although the term is more generally relevant to establishing a structured system to aid borrowers and lenders in achieving their objectives, structured finance is frequently used to describe the aggregation of receivables. 

The main objective is to make less risky products available to customers who need them and to target diverse asset classes across multiple sectors by facilitating financing solutions that do not entail free cash flow.

 Components of Structured Finance

The key components of structured finance are securitization, tranching, credit securitization, special purpose vehicles (SPV), and syndicated loans. Some of these important components are discussed in detail below.

Securitization

Such finance pools of assets through segmentation to create financial products that can better use the available capital or provide funding at a reduced cost, especially for originators with weaker credit ratings.

The foundation of structured finance is securitization. It is a technique used in structured finance to create complex financial instruments beneficial to businesses and investors with particular demands.

Securitization is beneficial since it helps customers monetize all asset classes, industries, and structural elements, including local and international transactions.

Features of Securitization

• Financing structures for special or complex requirements.
• Less emphasis on credit.
• Utilization of interest rates and liquidity to manage risk.
• Optimal use of available money to maximize the possibility of higher profits.
• Options for less expensive finance may be particularly crucial for borrowers with minute credit ratings.
• Risk can be moved out of investors' hands.

Tranching

When several classes of securities are produced from a single pool of assets, they often have distinct credit ratings. Tranching is a crucial aspect of structured finance as it underpins the system that divides securities into several investment classes.

The cash flow from the underlying asset can be distributed to different investor groups due to tranching. 

The creation of rated securities from a pool of unrated assets or the creation of at least one class of securities with a rating greater than the average rating of the underlying collateral pool are the main objectives of the tranching process.

In the credit and debt markets, tranches are frequently employed in the securitization process, which separates various debt instrument types and bundles them into funds for sale to investors seeking to profit from the debt's interest rate.

Investment bankers can put forth a group of loans with highly common traits that suit specific lenders.

Tranches of debt securities may have several payment options if the issuer defaults and has various credit ratings.

For instance, in the case of the issuer's bankruptcy or liquidation, senior tranches are paid before junior tranches since they have a higher credit rating.

Investments can be categorized as national or foreign, even though they can be divided into tranches based on maturity and interest rates.

Credit Enhancement

Credit enhancement refers to enhancing the creditworthiness of such financial products or transactions or enhancing the credit record of a structured finance transaction.

It is a crucial component of the structured finance securitization transaction and is significant for credit rating institutions when grading a tranche.

Any losses from the collateral are assigned to the subsidiary bonds before losses are given to the senior bonds, providing the superior bonds a credit boost. 

Therefore, failures in the repayment of the underlying assets are feasible without impacting payments to senior bondholders.

Over-collateralization and subordination are commonly used in transactions with riskier collateral, such as subprime and Alt-A mortgages. 

Overcollateralization occurs when the balance of the assets exceeds the value of the bonds, resulting in extra interest in the transaction that acts as a buffer or cushion against the underlying assets' devaluation. 

Such credit enhancement is possible by using excess interest to cover collateral losses before losses are distributed to bondholders.

Utilizing derivatives, such as swap contracts, which essentially offer insurance against a decline in value for a defined charge, is another way to improve credit.

Modern Credit Enhancements depend heavily on repo transactions; they are more efficient in;

• Overbalance models that generate artificial leverage, 
• Credit rating improvement with in-built asset derivative products 
• Transnational loans with debt holders and lenders within the counterparty insurer's domain.

Whether to employ a monoline insurer or not usually depends on the cost of the insurance compared to the increase in the price of the loan or bond issue as a result of the credit enhancement. 

For securities intended to be sold to investors, ratings are crucial in structured finance.

Numerous mutual funds, governments, and individual investors will only purchase securities that have received a favorable credit rating from a reputable organization, such as Moody's, Fitch, or S&P Global Ratings. 

Rating agency criteria have become more stringent due to new regulations in the U.S. and Europe since the 2007 - 2008 financial crisis. As a result, there are mainly two categories of credit enhancement: internal and external.

Internal Credit Enhancement

Internal credit enhancements are built-in securitization structure transactions to improve the risk profile and credit quality of the securitized assets and resulting securities. Internal credit enhancements are as follows.

Subordination/Credit Tranching

One of the most common methods for creating internal credit improvement is establishing a senior/subordinated structure. Asset cash flows are distributed to classes with differing levels of seniority according to distinct priorities. 

Thus, various tranches in the senior/subordinated system range from the most senior to the most subordinated. 

The less senior tranches provide a layer of protection for the more senior tranches. Therefore, the seniority-ordered tranche has the initial entitlement to cash flow.

Excess Spread

The difference between the interest rate paid on the underlying collateral and the coupon on the issued security is known as the excess spread. It is frequently one of the first lines of defense against default. 

The coupon payment may still be made even if part of the underlying loan installments are past due or in default. During the turbo process, the excess spread is assigned to exceptional classes as a principle.

Overcollateralization

With this support structure, the issued security is overcollateralized since the face value of the underlying loan portfolio is more than the security it backs. 

This way, principal and interest payments on the asset-backed security can still be made even if part of the payments from the underlying loans are late or default.

Reserve Account 

A reserve account is established to pay the issuing trust for losses up to the reserve amount. 

To improve credit support, the reserve account will frequently be non-declining during the duration of the security. This means that when the previous debt is paid off, the account will grow proportionately up to a certain amount.

External Credit Enhancement 

External credit requirements are rendered by the external third parties to the issuer or borrower. These enhancements are utilized to provide internal credit enhancements and further improve the credit quality of the securities. External credit enhancements are:

Surety Bonds

Surety bonds are insurance contracts that cover any damages incurred by an asset-backed security (ABS). They are external ways of improving credit. 

ABS linked with surety bonds have the same rating as the company issuing the surety bond. The provision of a bond as a means of a credit enhancement guarantee by surety firms is prohibited by law.

Wrapped Securities

A third party provides insurance or a guarantee for wrapped security. The pledge to compensate the trust for losses up to a specific sum may come from a third party or, in some situations, the parent firm of the ABS issuer. 

Agreements to buy back any defaulted loans or to advance principal and interest are additional examples of deals. In addition, Monoline insurance firms or financial guarantors often offer third-party guarantees with a AAA rating.

Letter Of Credit/LOC  

A financial institution is paid a fee to provide a certain cash sum to compensate the ABS-issuing trust for any cash shortages from the collateral up to the necessary credit support amount due to a letter of credit.

Cash Collateral Account / CCA

Credit enhancement is done using a CCA when the issuer borrows the necessary credit support amount from a commercial bank and puts this money in short-term commercial paper with the greatest attainable credit quality. 

A CCA is a real cash deposit; thus, if the CCA provider were to be downgraded, the security would not experience comparable degradation.

Types of Structured Financial Products

A structured product, sometimes referred to as a market-linked investment, is a ready-made structured finance investment strategy based on a single asset, a basket of securities, options, indices, commodities, debt issuance, foreign currencies, and to a lesser extent, derivatives.

Although underlying assets and derivatives in structured products come in various forms, they may be categorized into main categories despite their heterogeneity.

A desk often hires a dedicated structure to manage and design its structured product offering.

Generally speaking, structured products are appealing because of the following features:

• Principal protection, depending on the type of structured product
• Tax-efficient access to fully taxable investments
• Enhanced returns within an investment
• Reduced volatility (or risk) within an investment 
• Ability to earn a positive return in low-yield or flat equity market environments
• Ability to minimize issuer risk by using collateral-secured instruments (COSIs) backed with collateral in the form of securities or cash deposits 

Syndicated Loan 

A syndicated loan, often referred to as a syndicated bank facility, is a type of financing provided by several lenders collectively known as a syndicate that pools their resources to lend money to a single borrower. 

A firm, a sizable undertaking, or a sovereign state might be the borrower. In addition, a credit line, a set quantity of money, or a mix of the two may be included in the loan.

Syndicated loans are required when a project needs a loan that is too big for a sole creditor to provide or when a project requires a specialist lender with knowledge of a certain asset class. 

By syndicating the loan, lenders can distribute risk and participate in investment opportunities that might be too big for their capital bases.

Syndicated lending's major objective is to distribute the risk of a borrower who may default across several banks, lenders, or institutional investors, such as pension funds and hedge funds. 

Due to the increased size of syndicated loans compared to regular bank loans, even one borrower failing might be enough to bankrupt a single lender. 

In leveraged buyouts, syndicated loans are also utilized to finance significant company acquisitions predominantly using debt.

In the case of syndicated loans, the borrower's amount may be less than first anticipated if sufficient investors cannot be located. 

These loans can be divided into two tranches for banks funding typical revolving credit lines and institutional investors funding fixed-rate term loans.

Collateralized Bond Obligations (CBOs) 

An investment-grade asset backed by junk bonds, also known as non-investment-grade assets, is a collateralized bond obligation (CBO).

The pool of risky trash bonds that a CBO is backed by frequently has a high interest rate; the more the risk, the higher the interest rate an investor will get.

The junk bonds that support a CBO often have varying degrees of risk, which helps to balance the asset and qualify it as an investment-grade asset. Through the issuance of CBOs, junk bonds can be converted into investment-grade assets.

CBOs provide large fixed-income investors with a lower-risk way to take advantage of earning a high amount of profit through potential junk bonds.

Additionally, it gives large owners of junk bonds a means to lessen the risk associated with defaults by bundling and selling the bond receivables on their portfolios to investors.

Credit Default Swaps (CDS) 

A credit default swap (CDS) is a contractual arrangement wherein one party buys insurance from the other against losses resulting from a borrower's default for a predetermined amount of time.

The debt of a third party, referred to as the reference entity, is written with a CDS; this debt is known as the reference obligation and is often a senior unsecured bond.

Normally, a CDS issued on a specific reference obligation covers all liabilities of the reference company with seniority of equal or greater.

The credit protection seller and the credit protection buyer, both parties to the CDS, are said to be long and short the reference entity's credit, respectively. The CDS pays off when a credit event occurs, such as bankruptcy, nonpayment, or mandatory restructuring in some nations.

A CDS may be settled by the credit protection seller making a cash payment to the credit protection buyer based on the reference entity's cheapest-to-deliver obligation. 

The reference firm's debt is auctioned to establish the cash settlement payout, which provides the market's estimation of the likelihood of recovery. Even though the recovery rate may vary, the credit protection buyer must accept the auction's results.

Hybrid Securities 

A large category of securities known as hybrid securities combines the traits of the two larger categories of securities, debt and equity.

Until a specific date, hybrid securities provide a consistent (either fixed or adjustable) rate of return or dividend; after that time, the holder has various alternatives, including converting the securities into the underlying share. 

Thus, in contrast to a share of stock (equity), the holder benefits from a fixed (as opposed to residual) cash flow. In comparison to fixed-interest security (debt), the holder has the opportunity to convert the security to the underlying equity. 

In contrast to fixed-interest instruments, hybrid securities have a distinct structure. Others act more like the underlying shares into which they may convert, while some behave more like fixed-interest instruments in terms of pricing.

Collateralized Mortgage Obligation (CMO)

A mortgage-backed instrument known as a collateralized mortgage obligation (CMO) consists of a pool of mortgages that have been packaged together and offered as an investment. 

CMOs receive cash flows when borrowers pay off the mortgages that serve as security for these securities, which are organized by maturity and amount of risk. 

CMOs then pay out principal and interest to their investors in accordance with pre-established guidelines and agreements.

In addition to changes in interest rates, collateralized mortgage obligations are also susceptible to shifts in the economy's fundamentals, including rates of home sales, refinancing, and foreclosures. 

Bonds with monthly coupons are issued against each tranche, which varies in size and maturity date. The principal and interest rate on the coupon is paid each month.

CMOs had grown significantly in 2008, which was one of the main causes of the 2007 - 08 financial crisis.

Collateralized Debt Obligation (CDO) 

A CDO is a form of financial product backed by a collection (or pool) of fixed-income assets, such as mortgage-backed securities, market-traded corporate bonds, and credit insurance issued by the issuer through CDS in a synthetic CDO. 

The securities are broken down into many classes to broaden the pool of potential buyers. 

These are senior and subordinated tranches with varying principal and interest payment priorities, maturities, and interest rates, sometimes with an equity tranche at the lowest level.

The more junior tranches bear a higher interest rate since they are riskier assets. However, the more junior tranches have the right to priority of payment over the more senior tranches. A credit rating agency typically rates each tranche.

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