What is Structured Finance?
In simple terms, structured finance implies the design and availability of financial instruments and services that address complex financial needs. It is generally accessed by prime corporations who need to fix a looming financial problem that the existing stock of financial products cannot accomplish.
In addition to it, structured financing encompasses an extensive range of products and activities. Consequently, it can develop customised products to address the diverse requirements of a client, like funding, risk transfer, liquidity, etc.
Since the mid- 1980s, structured financial products have become prevalent within the finance industry. Here are some examples of structured finance instruments:
- Synthetic financial instruments
- Collateralised debt obligations (CDOs)
- Syndicated loans
- Collateralised bond obligations (CBOs)
Understanding Structured Finance
Structured finance is a rationalised and exclusive financial tool derived from assets like bonds and loans comprising complex transactions aimed to meet massive financial requirements. For multinational corporations, it is viewed as a robust option during a colossal financial crisis or predicament.
Typically, traditional financial instruments only sometimes address the sudden need for finance. Such financial instruments are used only when standard loans fail to meet the rising monetary requirements of a company. Not to mention, only some financial institutions or lenders offer such monetary aid, and not everyone is entitled to it.
Structured financing also enables credit risk transfer. It develops safe assets from a pool of cash-flow generating but unsafe assets. First, it includes practices like the merging of financial assets such as bonds, loans, and mortgages. Then, it is categorised into diverse risk classes, highlighted, and shaped tranches against such warranty pools.
Structured financial products are mainly recommended to borrowers, generally giant multinational corporations, where traditional financial instruments have failed. In most cases, such a form of finance includes incomplete discretionary transactions, leading to the application of risky and evolved financial tools.
Note: Structured finance instruments assets such as RMBS, CMBS, ABS, and CLOs are complex tools and hence not suited for every investor. Such assets may be open to risks like credit, issuer, underlying collateral, interest rate, liquidity, servicer, prepayment, and extension.
Benefits of Structured Finance
Traditional lenders to businesses do not offer structured financial products. The reason is structured finance is needed for crucial capital integration into a business.
In addition to it, these types of financial instruments are primarily non-transferable. It implies that such a form of financial product cannot be moved between several kinds of debts, unlike a standard loan.
Here is an overview of structured finance products and their benefits:
1. Asset-backed Securities (ABS)
Financial security made sustainable with a lease, receivable, or loan against assets is termed asset-backed securities. Such securities have floating interest rates instead of fixed ones that can shield corporations from the burden of higher interest rates.
Asset-backed securities, also known as ABS, are notes or bonds secured by cash flows from a particular pool of fundamental assets. Usually, such assets comprise receivables, except the mortgage loans like credit card receivables, home equity loans, auto loans, etc. The structure of such securities depends on the seller, the investor, and the issuer.
2. Mortgage-backed Securities
Mortgage-backed securities are a kind of investment, just like a bond created by a pack of home loans issued by banks. It makes the bank an intermediary between the financial institutions and the homebuyer. The bank sells the loans to investors at a discount as collateralised bonds.
Note: Mortgage-backed securities’ investors get periodic payments like bond coupon payments.
3. Collateralised Mortgage Obligations (CMOS)
A collateral mortgage obligation implies a kind of mortgage-backed security that includes several mortgages clubbed together and sold as an investment.
Classified based on the level of risk and maturity, collateralised mortgage obligations get cash flows as the mortgages are repaid by the borrowers that are used as collateral. Consecutively, the collateralised mortgage obligations distribute interest and principal payments to their respective investors, depending on preset agreements and norms.
4. Credit Derivative
In the first quarter of 2022, the estimated amount of credit derivatives jumped from USD 964 billion to USD 4.5 trillion. It is because a credit derivative is a type of financial contract that enables the lender to shift the debt instrument’s credit risk to a third party for a specific fee.
However, there needs to be an actual shift of ownership of the financial instrument. The lender is defended against the loss related to the risk of default by the particular borrower.
Conclusion
Structured financing reshapes cash flows and redesigns the financial portfolio liquidity by shifting the risk of the structured products from the sellers to buyers. Such forms of funding often sustained financial institutions extract specific assets from the balance sheets.
Hence, structured finance and its concerning products are significant. It sustains key borrowers looking for capital integration or a different source of financing when traditional borrowing options fail.
FAQs
No. It is not the same. In structured financing, complete recourse is provided to borrowers, while in project finance, only restricted recourse is offered to the parent companies. Also, in structured finance, historical and projected cash flows are evaluated, while in project finance, the future cash flow of a project is analysed.
Furthermore, structured finance can fund around 85% of the total project cost. While in project finance, about 15% of equity is required; hence the overall debt is below 85%.
Investment banks have an extensive range of product groups. One such group offers structured finance products. In simple words, structured finance is a set of complex transactions provided for financing purposes.