Structured finance is a financing structure concerned with transforming debts and liabilities into assets that generate capital flow for the parties that subscribe. The system provides subscribers with much-needed cash flow via a complex combination of sophisticated financial instruments and some off-balance-sheet accounting.
Structured finance differs from the traditional financing methods such as a loan or a bond. Unlike these traditional tools, structured finance provides financial solutions that help corporations ease the flow of working capital, restructure debt, and save on repayments without directly giving money.
Governments, financial institutions, and corporations use structured finance when a standard loan cannot cover the full extent of their operational costs. So, structured finance helps with risk management and the generation of necessary capital needed to sustain a business or venture into emerging markets. Structured finance also removes specific assets from the financial institution’s balance sheets.
An essential element of structured finance is securitization, a process in which financiers specially tailor assets and financial instruments using the subscriber’s unique needs or situation. Essentially, in the process of securitization, the financier comes up with a financial instrument by combining multiple financial assets into a single class which they eventually sell to investors.
Theoretically, any asset associated with liability can be transformed into a sellable item with monetary value. But, in this context, securitization involves the company with certain assets called the originator. The originator would gather relevant statistics on the asset it would like to take off its balance sheets. It might involve some personal loans or mortgages it is unwilling to continue servicing. The group of assets is combined to form what is referred to as a reference portfolio.
Moving forward, the originator would sell the reference portfolio to an “issuer” or financier whose job is to transform the portfolio into tradable securities. When, eventually, investors purchase the created securities, they do so at a designated rate of return because the securities confer a shareholder’s status on whoever invests in the portfolio’s assets.
Typically, the reference portfolio is broken down into multiple segments, often called tranches. Tranches are the individual assets defined by varying factors such as interest rate, date of maturity, among others. Summarily, each tranche is a slice of the securitized assets, represented based on the aforementioned factors and marketed individually to investors. However, each tranche holds different risk levels and yield rates. Often, tranches with higher risk levels garner a corresponding level of interest rates and possibly a higher rate of return.
A standard example of securitization is a mortgage-backed security. When mortgages are combined into a singular, extensive portfolio, the issuer breaks down the pool of assets into smaller pieces(tranches); each mortgage division has its defined risk level. Each portion is then marketed to investors as a kind of bond.
For further context, a mortgage-backed security portfolio may have tranches with one-year, seven-year, and 20-year maturities at different yield rates. An interested investor may choose the type of tranche that appeals to them the most regarding their capacity for risk and the intended return.
When an investor purchases the security, the originator successfully removes the asset from their balance sheets, reducing their liability. However, investors receive monthly cash flow from the interest payments of the original mortgage-owners. A tranche with a more extended maturity date will yield steady cash flow over a longer period.
The securitization process grants retail investors access to shares that might otherwise be unavailable or unaffordable. For example, the securitization of mortgages allows a small investor to buy a small amount of a large pool and enjoy the dividends of his investment.
Unlike other debt investment structures, these loan-based securities are relatively safe. If a debtor refuses to continue loan payment, perhaps their house, the property may be seized and liquidated to furnish stakeholders and investors with commensurate compensation.