Structured finance

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"Structured finance" is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities.

Contents

[edit] Definition

The Global Financial System provided a definition of structured finance in their January 2005 report, "The role of ratings in structured finance: issues and implications". It stated "Structured finance instruments can be defined through three key characteristics: (1) pooling of assets (either cash-based or synthetically created); (2) tranching of liabilities that are backed by the asset pool (this property differentiates structured finance from traditional “pass-through” securitisations); (3) de-linking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through use of a finite-lived, standalone special purpose vehicle (SPV)."[1] For an example of a structured finance deal please see Securitization.

[edit] Structure

[edit] Securitization

Main article: securitization

Securitization is the method which participants of structured finance utilize to create the pools of assets that are used in the creation of the end product financial instruments.

[edit] A securitization transaction

Main article: Securitization transaction

Because securitization is such an important tool used in structured finance, it is important to see how a securitization transaction would actually occur.

[edit] Tranching

Main article: Tranche

Tranching is an important concept in structured finance because it is the system used to create different investment classes for the securities that are created in the structured finance world. Tranching allows the cash flow from the underlying asset to be diverted to the various investor groups. The Committee on the Global Financial System explained tranching succinctly: "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 prioritisation of payments to the different tranches."[1]

[edit] Credit enhancement

Main article: Credit enhancement

Credit enhancement is key in creating a security that has a higher rating than the issuing company.

[edit] Credit ratings

Main article: Credit rating agency

Ratings play an important role in structured finance.

[edit] Structure

[edit] Other structures

There are numerous structures which may involve mezzanine risk participation, Options and Futures within structuring of financing as well as multiple stripping of interest rate strips. There is no laid-out fixed structure unlike in Securitization which is only a subset of the overall structured transactions. Esoteric transactions often have multiple lenders and borrowers distributed by distribution agents where the Structuring entity may not be involved in the transaction at all.

[edit] Types

There are several main types of structured finance instruments.

  • Asset-backed securities (ABS) are bonds or notes based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets.
  • Mortgage-backed securities (MBS) are asset-backed securities whose cash flows are backed by the principal and interest payments of a set of mortgage loans.
  • Collateralized debt obligations (CDOs) consolidate a group of fixed income assets such as high-yield debt or asset-backed securities into a pool, which is then divided into various tranches.
  • Collateralized mortgage obligations (CMOs) are CDOs backed primarily by mortgages.
  • Collateralized bond obligations (CBOs) are CDOs backed primarily by corporate bonds.
  • Collateralized loan obligations (CLOs) are CDOs backed primarily by leveraged bank loans.
  • Credit derivatives are contracts to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset.

[edit] External links

[edit] See also

[edit] References

  1. ^ a b The Committee on the Global Financial System defined Structured Finance, "The role of ratings in structured finance: issues and implications", January 2005
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Structured finance
Securitization
Types of Securities

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