What is Structured Finance
Structured finance involves a high financial instrument which is usually offered to big corporations or companies that their financial needs are too complex and does not match the normal financial products. For over a very long period of time, structured finance has become the need of many financial companies or corporations.
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Some of the examples of structured finance are the CDOs which means Collateralized debt obligations, synthetic financial instruments, the CBOs which has its meaning as Collateralized bond obligations and loans syndicate.
Types of structured finance
There are various types of structured finance; some of which are listed below.
- Asset backed security:This represents the use of underlying asset to serve as collateral or using assets to have its base on bonds.
- CDOs:This is known as collateralized debt obligations. This have assets backed securities divided into different sections. It has some fixed income assets consolidated. Examples of this CDOs are collateralized bond obligations, collateralized loan obligations, commercial real estate collateralized debt obligations and synthetic financial instruments.
- Collateralized bond obligations:These are CDOs that are used by corporations issuing bonds.
- Collateralized loan obligations: These are the CDOs that are used by banks that practice leverage loan financing.
- Commercial real estate collateralized debt obligations: These are used by real estate management companies that are into bonds and loans.
- Insurance linked security: These are instruments of risk that are used to do insurance in case of any bad occurrences or damages within the company.
Other types of structured finance are the mortgage backed securities, collateralized fund obligations which are used by companies that practices equity financing, partial guaranteed structures, loan sell off etc.
This sector of finance aims at the help of creating transfer of risk with the use of corporate companies. This risk that is transferred is the securitization of most financial assets of a company and has provided increased funding strategy to corporations and has also helped in transferring of risk to structured products buyers. This financial asset can be credit card receivable, auto loans or mortgages. Structured finance has helped corporations to be able to divert their assets into classes.
Methods in structured finance
- Credit enhancement: This is used in securitization under structured finance for creating a high rating security than the pool of underlying asset. This is usually created by issuing or using of subordinate bonds. The subordinate bonds are any losses from the collateral allocated before there is allocation to the senior bonds making use the senior bond as credit enhancement. So as a result, many deals especially those with higher risk of collateral such as alt A-mortgages make use of subordination and over collateralization. In over collateralization, the returns of the underlying assets are greater than the bonds consequently creating over interest rate in a deal which is supposed to act as cushion in against any reduction in the value of the underlying assets. These over interest can be used to pay off the losses of the collateral before allocation of losses to the bondholders. The use of derivatives like stock options, warrants or swapping which provide an effective insurance for fees that stands against the value decrease is another way of credit enhancement. Monoline insurers can be used in credit enhancements as they have played many roles in this modern credit enhancement.
- Securitization: This is a method used by the user of structure finance to generate pools of assets that helps in the formation of the financial instrument end product. There are many reasons for securitization; which are for another means of funding, better maximisation of the capital available to the company, reducing of concentration of credit use and for transferring of risk.
- Tranching: This is used in the creation of many session and parts of security from the pool of assets that was used before. This helps in creating different classes of investment for the available securities. Tranching makes it possible and provide opportunity for the cash flow got from the underlying assets to be used in finance other investors group. The main purpose of tranching is to create a security class even if it is one class of security that its rating is very high than the underlying collateral pool rating.