Structured Finance

Structured Finance is a complex financial instrument offered to borrowers with unique and sophisticated needs. Generally, a simple loan will not suffice for the borrower so these more complex and risky finance instruments are implemented.

Collateralized debt-obligations, syndicated loans and Mortgage-Backed Securities are all examples of Structured Finance, particularly where securitization of cash flows is involved.

Structured Finance is usually used on a scale too large for an ordinary loan or bond. It can also be a structure for private lending projects, particularly driven by a large construction project, where securitization of cash flows is not involved.

For anyone trying to learn more about this 6 trillion-dollar market:

It involves the structuring of cash flows – inflows and outflow -- and the scheduling of amounts where Present Values (PV) of the flows are calculated as well as Internal Rates of Returns (IRR) to achieve optimums. All with an objective of optimizing the value of the project to the funder as well as the user of the barrowed financial capital – such as a development project (commonly found in both Private Projects and Municipal Project Finance and their various muni-bond structures).

For the underlying theoretical definitive statement on the theory of how to treat various cash flow streams and structural adjustments see: Irving Fisher, “Theory of Interest”.

Project finance and production drawdowns (stage payments) requirements, in the case of building projects, will drive the structure of the financing and/or a particular securitization of,say, a bond issuance or derivative creation (or usethereof) if a standardized market instrument that can be traded.

There maybe particular considerations; such as, how secured are transactions, trusts arrangement, corporation particulars of the barrowers, securities regulation, effects on overall corporate finance, tax, banking, accounting or even bankruptcy. All or some of which can effect the final structure of the financing instrument structure (which can be complex) and the market it might be sold into.

Other considerations:

Securities Laws and The Investment Company Act;

Banks and Securitization;

International and Cross-Border Issues with Securitization; such as currency risk.

A derivativeinstrument structure might be a choice. 

What is a Securitization? It is the creation of a security

What is a derivative instrument? It is a security

Derivatives are financial contracts that get their value from underlying securities such as MBSs, CDOs and stocks and bonds. Options, such as puts and calls as well as futures contracts, are also derivative instruments.

Banks use derivatives to repackage individual loans into a product sold to investors on the secondary market. This allows them to get rid of the risk of holding the loans until maturity. It also gives them new funds to lend.

An example of a complex derivative structure when it comes to a securitization might be the securitization of a mortgage loan pool where the derivative might look like this:

An Australian currency bond where several loan payment tranches are secured separately as, say, tranches 1,2,3,4, . . . Z are each of different structures and behave differently as to market price and cash flows under different market interest rate occurrences over time.

A very complex example!

Example:An Australian currency denominated inverse IO (interest only) or PO (principal only)cash flow, say, from the 4th cash flow tranche of mortgage payments.

Complex to evaluate as first we have currency movement considerations and then market interest changes affectingboth the underlying mortgage loans and their prepayment behaviors (affecting both IO and PO) as well as thebehavior of the market price of the trading derivative bond.

Much complexity can be brought to bare in attemptingto optimize both barrowers and investors objectives in participating in these customized structures. 

Tranches in Mortgage-Backed Securities.

tranche is a common financial structure for securitized debt products, such as a collateralized debt obligation (CDO), which pools together a collection of cash flow-generating assets—such as mortgages, bonds and loans—or a mortgage-backed security (MBS).

The word tranche is French for 'slice', 'section', 'series', or 'portion', and is a cognate of the English 'trench'.

In Structured Finance, a tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk.

A CDO (Collateralized Debt Obligation) is called asset-backed commercial paper if it's based on a bundle of corporate debt. It's a mortgage-backed security (MBS) if it's based on a bundle of home loans.

Most mortgage-backed securities are based on adjustable-rate mortgages. Each mortgage charges different interest rates at different times. Some MBS buyers would rather have the lower risk and lower rate. Others would rather have the higher rate in return for the higher risk. Banks sliced the securities into tranches to meet these different investor needs. They resold the low-risk years in a low-rate tranche, and the high-risk years in a high-rate tranche. A single mortgage could be spread across several tranches.

Institutional Investors can use these complex derivative bonds, for purchase, as hedge interments to offset negative market pricing or other financial behavior risk in mitigating the perceived overall corporate net interest rate change risk.

Financial Managers should take the opportunity to examine the actual legal documents used to implement this type of financing transaction when evaluating credits and how these securities might fit into their overall investment portfolio objectives.

A Tranche allows you to invest in the portion of the debt pool with similar risks and rewards. They were widely used during the 2008 financial crisis. Some experts believe these derivatives helped cause the crisis by hiding bad loans. 

In 1999, the safe and predictable world of banking changed forever. Congress repealed the Glass-Steagall Act.

Banks then made more money from mortgage-backed securities than they did from the mortgages.

The MBS became so complicated that buyers couldn't determine their underlying worth. Instead, they relied on their relationship with the bank selling the tranche. The bank relied on the “quant jock” and the computer model.

The assumption underlying all computer models was that housing prices always went up. That was a safe assumption until 2006. When home prices fell, so did the value of the tranches, the mortgage-backed security, and the economy.

When housing prices plummeted, no one knew the value of the tranches.

No one could price the mortgage-backed securities. As a result, banks stopped lending to each other. The credit markets froze up.

Derivative securities can be so complicated, it's hard to know whether they meet investors' asset allocation and diversification goals.

Private Deals

In the world of private equity, Structured Finance usually involves lending structures that are so complex that there is no derivative form that can be sold easily into the general securities market and would not even be considered a “security”.

In most cases, it is just a highly structured very large construction project loan of long duration. These loans are usually done by a consortium of investment bankers and commercial banks the size of City Bank, Bank of America, JP Morgan, Goldman Saks, Solomon Brothers, etc.

There is the funding portion to match construction drawdowns and the long term duration of the final loan. Their structure might involve currency and interest rate swaps, credit default swaps, risk hedging and the loans are usually held to maturity by the large banks and the consortium. “Participations” can also eventually be sold off to private equity institution investors such as insurance companies thus circumventing the securities markets.

Structured finance is a greatly involved financial instrument presented to large financial institutions or companies with complicated financing needs that don't match with conventional financial products. Structured finance also involves Financial Law that manages leverage and risk strategies that may involve legal and corporate restructuring, off balance sheet accounting, or as we have seen, the use of financial instruments of a derivative nature.

A Credit Default Contract can also be a part of a structured financing

ACredit Default Contract as a general term for securities with a risk level and pricing based on the risk of credit default by one or more underlying security issuers. Credit default contracts include credit default swaps (CDS), credit default index contracts, credit default options and credit default basket options. Credit default contracts are also used as part of the mechanism behind many collateralized debt obligations(CDOs); in these cases, the contracts may have unique covenants that exclude company events such as a debt restructuring as a credit event.

In most cases, structured finance involves one or several discretionary transactions to be completed, thus evolved and often risky, derivative instruments must be implemented.

Contact Us for more information on this huge and diverse market for specialized financing structures