Structured finance refers to a sector of finance that involves bundling cash-flow producing financial assets and repackaging them into securities that can be sold to investors. Some of the most common types of structured finance securities include collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and asset-backed securities (ABSs).
Structured finance provides several benefits, including providing more funding sources for the entities that originate financial assets, allowing investors to gain exposure to asset classes they otherwise could not invest in, and enabling the transfer of risk from entities less equipped to manage it to others more willing and able. However, structured finance also played a central role in the 2008 financial crisis, as poor understanding of the risks and weak oversight contributed to systemic problems when highly rated structured finance products began incurring major losses.
Nonetheless, structured finance continues to be an important part of global capital markets when applied judiciously. This article provides an overview of structured finance, its major components, risks and mitigants, key participating corporations, and how tech startups can make wise use of structured products.
Key Components of Structured Finance
Structured finance derives its name from the creation of financial instruments that are constructed by bundling and pooling cash flow producing assets. The resulting securities can be carved up into tranches that have different risk-return profiles to appeal to various investor appetites. Below are some of the central building blocks of structured finance deals:
Origination – The first step in structuring a financing is the origination of the assets that will be packaged together. Most structured finance products start with banks and financial services firms originating loans, leases, mortgages, and other assets that generate predictable future cash flows that can be pooled together.
Pooling and Structuring – Once the assets are originated, the next step is to bundle and aggregate them together into a pool. The pool creates diversification and the cash flows can then be structured into different classes of securities to meet investor demand. Credit rating agencies also typically provide ratings on the different tranches to indicate their risk levels.
Credit Enhancement and Tranching – Since the structured financing securities ultimately depend on the underlying pool of assets for paying interest and principal, additional protection is often provided. This frequently comes in the form of overcollateralization (more assets than bonds), waterfall payment structures, swap guarantees, and reserve accounts. The pool is then structured into one or more tranches with varying credit ratings, risks, and yields based on their place in the payment waterfall.
Servicing and Administration – Since the underlying assets for structured finance deals tend to be loans and receivables, they require ongoing administration like collecting payments and maintaining borrower records. A servicer will handle tasks like collecting principal, interest, and escrow payments on mortgages and transmitting them to trustees and investors.
Biggest Players in Structured Finance
Structured finance is a global industry with issuers and investors domiciled across North America, Europe, and Asia Pacific. According to research from GoldenTree Asset Management, the worldwide structured finance market totaled over $3 trillion across various asset classes as of year-end 2019.
Many of the world’s largest financial institutions are active participants in structured finance, but below are a few specific leaders:
JPMorgan – Since the early days of structured finance pioneering collateralized loan obligations (CLOs), JPMorgan has remained an industry leader. It is consistently one of the top underwriters of CLOs and handles origination, structuring, distribution, and trading.
Citigroup – For over three decades, Citi has been a market leader in structured finance with global franchises in areas like mortgage-backed securities (MBS), asset-backed securities (ABS), collateralized debt obligations (CDOs) and more. It offers comprehensive structured finance services from origination through distribution.
Wells Fargo – As a leading U.S. commercial and retail bank, Wells Fargo plays important originating and distribution roles in many domestic structured finance sectors. It is particularly active in areas like mortgage finance, securitizing auto loans, equipment leases, credit card debt, and more.
Goldman Sachs – Goldman Sachs has consistently been one of the biggest structured product issuers over the past decade. It actively originates, structures, and distributes various forms of MBS, CDOs, CLOs, and other bespoke structured financings.
Advantages of Structured Finance
When applied judiciously and the risks are adequately understood, structured finance products offer worthwhile advantages to both issuers and investors:
Enhanced Liquidity and Funding – For the originators of loans and other cash flow producing assets, selling them into securitization markets provides more sources of upfront funding and liquidity. This includes assets like mortgages, auto loans, credit card debt, equipment leases, royalties, and more.
Diversification and Risk Transfer – Bundling together loans or other assets creates increased diversification compared to being exposed to the credit risk of individual borrowers. Issuers can then transfer concentrated risks off their balance sheet to investors with greater risk tolerance and more dispersed exposure.
Lower Funding Costs – When predictable assets are pooled and sold to structured finance investors, issuers can often fund the assets more cheaply compared to portfolio lending approaches. Credit enhancement and tranching also facilitate investment grade ratings that allow for reduced borrowing rates.
Targeted Investor Access – Tranching cash flows into distinct securities allows the structured finance market to offer a range of products tailored to the unique needs of investors like insurers, pension funds, asset managers, hedge funds, and more. Products can be crafted to investor constraints and risk appetites.
Disadvantages and Risks
However, structured finance also comes with distinct disadvantages and risks that participants must appreciate and safeguard against:
Complexity and Transparency – The complexity inherent to structured finance with pooled assets tranched into layered securities can hamper transparency. Weak disclosure and reporting requirements further obfuscate understanding true investment risks.
Leverage and Speculation – High leverage and overspeculation are often enabled through structured finance vehicles since they allow investors with less capital to gain exposure. But high leverage also introduce major risks should cash flow assumptions come under pressure.
Misaligned Incentives – Certain conflicts of interest are inherent to structured finance, like ratings agencies being paid by the issuers they are supposed to objectively assess. Investors must guard against the risk incentives encourage ratings to be higher than warranted.
Illiquidity – Unlike simple stocks and bonds, complex structured products often have indirect risks and cash flows that make them difficult to accurately value and price. This also hampers the ability to trade them on secondary markets contributing to illiquidity risks.
How Fintechs Utilize Structured Finance
Financial technology innovators (“fintechs”) have found compelling ways to utilize structured finance products to fuel their rapid growth:
Online Lenders – Alternative lending fintechs use securitization to bundle together loans and then sell structured products to investors to raise funds for further lending. This avoids slow bank credit processes allowing nimbler financing of consumers and SMEs.
Invoice Discounters – Fintech invoice discounting startups purchase outstanding customer invoices from suppliers at a discount, earning the spread once paid. But securitizing and selling tranches of the invoices generates large capital pools for bigger market impacts.
Mortgage Companies – “Non-bank” mortgage lenders avoid cumbersome bank mortgage processes. But they depend on structured finance and pooling home loans into mortgage-backed securities to raise funding via global capital markets to create liquidity for more mortgage originations.
Ecommerce Firms – Large amounts of online seller inventory and expansion requires major financing. But ecommerce companies too small for corporate bond markets or IPOs can enable more growth by packaging income streams into structured financing products for institutional investors.
Regulating Structured Finance
Poor oversight and weak controls left structured finance largely unregulated ahead of the 2008 Global Financial Crisis. However, major reforms have since attempted to strengthen guardrails and fill gaps exposed that enabled excessive risk concentrations that became systemic. Below are the most impactful reforms:
Dodd-Frank Act (U.S.) – Passed in 2010 after the crisis, the Dodd-Frank Wall Street Reform law enhanced reporting for issuers of asset-backed securities, mandated new rating agency oversight, required banks to retain some risk exposure on products sold, and expanded enforcement.
CRR/CRD IV (Europe) – The CRR/CRD IV regulatory package improved bank capital adequacy ratios, leverage limits, counterparty risk management, and liquidity risk handling. This guards against bank failures due to exposures to complex derivatives and structured products.
SIFMA Best Practices – The Structured Finance Industry Group has also issued best practice guidance and principles around information access, disclosure, reporting, governance, and analytics to support better controls and oversight of structured finance globally.
Future of Structured Finance
Looking ahead, structured finance will likely continue evolving in a few critical ways:
Synthetic Structures – Alternative risk transfer structures that use derivatives to simulate pool exposures without physical asset transfers could see increased usage as new rules limit certain securitizations.
Technology Focus – Fintech innovation and automation around origination, custom structuring, risk modelling, data analytics, and reporting will improve access, compliance, and transparency around structured products.
ESG Alignment – Sustainability objectives around better environmental stewardship, social responsibility, and governance discipline will drive increased focus on sustainable structured finance issuance.
Conclusion
In conclusion, structured finance involves bundling and pooling financial assets to construct tailored securities that appeal to distinct investor risk and yield preferences. Used prudently, structured products enable enhanced liquidity and risk transfers while providing economies of scale and capital access. However, weak controls and misuse of excessive leverage also enable speculation and instability. As regulations continue enhancing oversight and fintech innovations drive positive structural shifts, structured finance will likely continue modernizing into a more transparent, accessible, and sustainable market.