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Structured Finance
Structured finance instruments can be defined through three key characteristics:
- Pooling of assets (either cash based or synthetically created)
- Tranching of liabilities that are backed by the asset pool (this property differentiated structured finance from traditional "pass-through" securitizations)
- Delinking of the credit risk of the collateral asset pool from the credit risk of the originator, usually through use of finite-lived, standalone special purpose vechile (SPV).
While this definition is still very broad, it helps to explain the characteristicts of these instruments. Now that we have this defined structure, let me explain why these instruments are useful. First, the need for these instruments grew tremendously in the 1990s as lenders (banks) wanted to remove debt securities they issued (loans, mortages, etc.) from their balance sheets. Banks were not easily able to sell these securities to investors because, by themselves, they involve a significant amount of credit risk and few investors wanted to invest in them directly.
Secondly, large asset management firms stepped in to help purchase these securities and, through methods which I will explain, issue new securities that are more appealing for investors. The asset management firms would buy many of the same asset types from the banks and create a SPV that issues an amount of debt equal to the amount of the securities that the asset management firm purchased from the bank. The debt that is issued is tranched which creates several securities that have very different characterists from the underlying collateral and is more appealing to investors. The new securities can have either a very safe (low return and low volatility) or a very risky (high return and high volatility) aspect.
In this section, I have created the following pages on Structured Finance:
- History - Here is a brief history of Structured Finance.
- Types - Explains the some of the various types of Structured Finance instruments available today.
- CDO - Collateralized Debt Obligations are the fastest growing area of Structured Finance and it is the area I have primirarily work in.
- References - Contains links to various useful sites.