Structured Finance Definition Products Examples How It Works

Structured Finance Definition

It covers a wide range of activities and products. The technique creates tailor-made products to meet the client’s requirements involving funding, liquidity, risk transferRisk TransferRisk transfer is a risk-management mechanism that involves the transfer of future risks from one person to another. One of the most common examples of risk management is the purchase of insurance, which transfers an individual’s or a company’s risk to a third party (insurance company).read more, etc. Some of the product examples falling into the realm of structured finance are asset-backed securitiesAsset-backed SecuritiesAsset-backed Securities (ABS) is an umbrella term used to refer to a kind of security that derives its value from a pool of assets, such as bonds, home loans, car loans, or even credit card payments.read more (ABS), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), and collateralized debt obligationsCollateralized Debt ObligationsCollateralized debt obligation (CDO) refers to a finance product offered by the banks to the institutional investors. Such tranches have a complex structure and derive their value from the various underlying assets like loans, mortgages and corporate bonds, which also serve as collaterals in case of default.read more (CDOs).

Key Takeaways

Structured finance involves designing and delivering sophisticated financial products and services to satisfy complex financial requirements.The consumers of it are the large entities with complex financial issues or requirements seeking tailor-made products superior to the conventional financial instruments.Examples are asset-backed securities (ABS), commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), and collateralized debt obligations (CDOs).Corporate finance is a different concept. It focuses on the commercial activities of an entity and maximizing shareholders’ value.

Structured Finance Explained

Structured finance is the updated and exclusive instruments derived from a pool of assets like loans and bonds involving complex transactions servicing big financial needs. It is a powerful option in times of crisis and emergency and for large corporations with significant financial needs. These instruments are accessed when the standard loans do not cover the financial requirements of an organization. In other cases, the traditional debt instrumentsDebt InstrumentsDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more fulfill the need for finance. Also, not all lenders or financial institutions Financial Institutions Financial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read moreoffer such finances, and not all entities are eligible.

It facilitates credit risk transfer. From a pool of riskier assets, it creates safe assets. First, it comprises practices such as pooling financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash.read more like loansLoansA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, and mortgages. It is then divided into distinct risk classes, prioritized, and formed tranches against these collateral pools. Many structured tranches are significantly safer than an average illiquidIlliquidIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment.read more asset included in the underlying pool due to the priority system utilized in claim structuring.

The key benefit of it is that it provides huge financing extensively to confront contingencies and to bag big opportunities. For example, when a company decides to expand its business in new territories or start a new venture, they often apply for structured instruments. A bundle of complex transactions provides a much larger amount than small loans and mortgage financing options. Moreover, it brings the parties involved, such as large institutions and big commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more, together; the number of funds made available and circulated through the economy is massive.

Examples

CDOs are an important structured finance product exemplifying a form of asset-backed securitization. The intermediate bank bundles loans, mortgages, and other assets converting them to tradable capital market debt instruments and offer to investors indirectly. The tranches include a junior, mezzanine, and senior tranches. Its issuance helps issuers fulfill many financial objectives, including off-balance-sheet securitization, regulatory capital requirements management, and exposure to alternative asset funding sources.

Enhanced equipment trust certificates (EETCs) (sponsored by lessees) and asset-backed securities (ABSs) (sponsored by lessors) have long been an affordable, convenient, and common way to fund aircraft, particularly older aircraft. A credit enhancement for these structured finance instruments for lessening the impacts of defaults is known as a DIP or liquidity facility in the aircraft world. It functions similarly to an overdraft, preventing cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more problems. This feature is beneficial to investors in EETCs, ABSs, and other lending structures, but it can also give false hope by just papering over the cracks.

Structured Finance Definition Products Examples How It Works