Understanding Structured Finance and Structured Finance Products
Structured finance is a financial instrument available to major financial institutions and corporations with complex or unique financing needs. Conventional financiers loan money after assessing a company’s assets and market value.
This, however, may not be sufficient for businesses facing unforeseen emergencies or crises. For instance, banks hoping to expand their operations urgently to take advantage of a new opportunity ahead of their competitors require special funding superior to conventional financing. Therefore, they prepare packages with several revenue sources to attract lenders. They pool resources, including loans, mortgages, and bonds, and divide them into classes based on risk levels. Lenders can choose the assets that meet their risk tolerance and offer financing in return.
Like traditional financing, there is also a risk of default in structured funding, especially when the initial borrower of loans or mortgages becomes bankrupt. Banks subdivide assets and categorize them based on these risks. High-risk products offer high-interest rates for lenders, while low-risk products come with low-interest rates and long tenors. However, in both cases, lenders retain the initial borrower’s assets as collateral for repayment.
Lenders provide financing after evaluating the bank’s cash flows. This means corporations with illiquid assets but a history of reliable cash flow are eligible for this financing. Structured finance products are non-transferable, meaning holders cannot convert them into other debt types like standard loans.
Structured financing is beneficial because it enables organizations to access major funding promptly when needed. Furthermore, businesses can derive significant liquid assets from their illiquid infrastructure as an additional source of financing.
The common structured finance products are collateralized debt obligations (CDOs) and collateralized bond obligations (CBOs). Banks offer CDOs by bundling various loans together. Lenders can buy these loans and wait for them to mature after 10 years.
Additionally, lenders receive periodic interest payments from the initial borrowers and the principal amount of the loan. Banks subdivide CDOs into tranches that reflect risk levels. When initial borrowers successfully repay these loans, lenders of senior debts receive payment ahead of everyone else. They then pay the other investors based on priority.
CDOs are beneficial to banks since they help reduce risks on their balance sheets by transferring them to lenders. Moreover, banks can liquidate their assets quickly to expand their funding capacities, depending on their project requirements. CDOs are also beneficial to lenders since they help diversify their investments by buying packages with various assets spread over many loans.
CBOs, on the other hand, are structured products that bundle together junk bonds. Junk bonds have a high risk of default, particularly those that come from institutions in financial trouble. Banks pool bonds that would otherwise be risky and offer them to lenders in exchange for financing.
Similar to CDOs, banks issue CBOs in tranches to reward different lenders based on risk levels. Lenders receive a principal amount after maturity and an annual coupon rate. However, this product is more attractive to lenders than CDOs since it is overcollateralized. This means that CBOs are backed by collateral worth more than the money issued to the banks initially. This way, lenders can still receive principal and interest payments after defaults on the underlying bonds.
Additionally, lenders invest in CBOs because they have high returns. By bundling together high-risk bonds, the package offers investors higher interest rates than other fixed-income debt securities. Moreover, lenders can benefit if the borrowers’ finances improve. In this event, junk bonds’ value appreciates and raises the return on investments.