An introduction to Structured Finance and its instruments

by Valerio Franzoso
Jan. 8, 2020
4 minutes

Structured finance is a branch of finance that was born in the USA and UK in the second half of the eighties, following a massive deregulation of the financial sector. These strategies have the aim of converting typically illiquid assets into liquid assets by redistributing the associated risks within the financial system. This is done through the so-called “securitization” of assets, where single financial instruments, such as debts, are pooled in a new security, backed by the same underlying assets.

The Process of Securitization

The process of securitization is necessary since individual loans have different characteristics that inevitably affect the liquidity of the asset. By combining these assets into a single security it is therefore possible to standardize their features and risks, making the instrument more appealing to capital market players. The securitization is carried out according to the different risks criteria of the loans: “senior” (low risk), “mezzanine” (average risk) and “junk” or “junior” (high risk). Once securitized, these assets can also be purchased in small tranches. This process of fragmentation reduces the general level of risk of the entire financial sector.

Debt

Pretty much all different types of instruments created through processes of structured finance belong to the sphere of private debt, and are further divided into two sub-categories a) bank-issued loans (including secured, unsecured, revolving loans, sight loans, mortgages, soft loans, and others), commercial paper, promissory notes, microcredit or b) a combination of the aforementioned categories, such as loans with peculiar features, taking the form of mortgages or bonds as a result of structured finance process.

Main instruments

The main instruments of structured finance are:

  • Syndicated Loans (“pooled” loans). They are loans conceded by a multitude of credit institutes, pooled together in order to provide a particularly risky loan to a single subject, while at the same time redistributing the risks among all institutions participating the pool.
  • Asset-Backed Securities (ABS). They are financial instruments that represent a group of underlying securities that would otherwise be illiquid or hard to place on the market from which come out a cash flow. The value of the title is defined by the value of the underlying assets.
  • Hybrid securities. These securities combine several financial instruments. As a result, they combine typical features of both bonds and equities (such as convertible bond) but are nonetheless influenced by the prices of the security in which they can be converted in.
  • Synthetic Financial Instruments. They are asset created to replicate the payoff of an instrument by using different types of securities. The aim is to join the specific needs of an investor without using that specific instrument that would generate this kind of cash flow. These instruments are often used for tax optimization.
  • Mortgage-Backed Securities (MBS). They are securities whose underlying assets are a single mortgage contract or a group of them. Usually, these instruments are able to generate periodic payments, linked to the individual underlying securities: the higher the number of periodic payments, the higher the risks associated with the mortgages. Therefore, they are often rated in order to balance the emissions with the associated risk of default.
  • Collateralized Debt Obligations (CDOs). They are very complex instruments, composed of securitised bonds whose repayment is exclusively based on a basket of other securitised loans, such as ABS. These instruments can take different forms. Some allow leverages on the underlining assets, while others allow their replacement, given the occurrence of events there were previously defined. These instruments are also divided into different tranches, according to their risk of default. It goes without saying that the value of these instruments is inevitably linked to the value and solidity of the underlying assets.
  • Collateralized Bond Obligations (CBOs). They are a variant of CDOs. Normally, these instruments take the form of a bond, backed by a combination of investment-grade and junk debts as underlying assets. This makes CBOs more appealing, since they can provide higher returns compared to instruments that are only backed by investment grade securities. However, they still bear an investment-grade rating, since their extreme diversification makes them a good investment fit for all capital market operators that would not be able to hold junk-rated instruments by statute.
  • Collateralized Mortgage Obligations (CMOs). A variant of CDOs that usually bear a fixed-rate coupon, backed by mortgages. The securitized instruments are usually segmented according to their risk, influencing the final returns of the instruments themselves.
  • Collateralized Loan Obligations (CLOs). Similar to CMOs, with the only difference being that they have loans or pooled loans as collateral, instead of mortgages.
  • Credit Default Swap (CDS). This type of instrument is particularly useful to transfer the risks associated with a specific issuer of debt. On the one hand, buyers will have to pay a premium, linked to the maturity and risk of the asset. On the other hand, vendors have the obligation to guarantee (and eventually reimburse) the securitized debt in case of a specific event, such as an eventual bankruptcy of the issuer.
  • Credit-linked Notes (CLN). These instruments are linked to CDS and allow credit risks to be transferred to another party. Such securities are usually issued through ad-hoc vehicles, so-called special purpose vehicles (SPV), or trusts that have investment-grade securities (AAA) as collateral. Similar to other instruments, CLN also provides periodic cash flows during their lifetime. Structured finance is a branch of finance that was born in the USA and UK in the second half of the eighties, following a massive deregulation of the financial sector. These strategies have the aim of converting typically illiquid assets into liquid assets by redistributing the associated risks within the financial system. This is done through the so-called “securitization” of assets, where single financial instruments, such as debts, are pooled in a new security, backed by the same underlying assets.
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