Structured Finance - Definition, Securitization, and Consolidated Financial Instruments.

What is Structured Finance?

Ans:- Structured Finance is an important source to meet the complex funding needs of large financial institutions (like- Banks, NBFCs etc.) or Companies, that would not be fulfilled by a simple loan or, are unsatisfied with traditional financial products (like- Stocks, Bonds, etc.).

➜ Structured finance refers to securities, where promise to repay the investors is backed by the underlying financial assets. 

➜ It is called "structured" due to the fact that the securities included in these financial transactions are backed by bunch of underlying assets and mortgages called collateral.

To create a Structured financial instrument, Securitization is the process or method by which certain types of assets are pooled so that they can be repackaged into interest-bearing securities (Bonds).

Structured Financial Instruments represent a broad sector of financial instruments and. This sector include:-

➠ Asset Backed Securities (ABS),

➠ Mortgage Backed Securities (MBS), 

➠ Collateralized debt obligations (CDO),

What is Securitization?

Ans:- Securitization is a process by which a company (Generally Banks or NBFCs) sells some of its assets, which it wants to remove from its balance sheet, to an entity called Special purpose entity (SPE). SPE then clubs the assets purchased to form consolidated financial instruments (generally ABS, MBS etc.). later these financial instruments are sold to investors to finance the acquisition of assets purchased by SPE.

Example:- Suppose a Non-Banking Financial Corporation (NBFC), has $100 million of housing loans and this amount is shown on NBFC's Balance sheet as an asset. This company wants to raise fund by issuing bonds. however, its debt-equity ratio is quite high and business prospects do not seems to be that good. So, it would be difficult to raise bonds at lower cost. In such situation the NBFC (called Originator) sells some of its assets (which is housing loans in their asset side of the balance-sheet) to a Special Purpose Entity (SPE). The SPE in-turn issue security to investors, these securities are known as ABS or MBS. The EMIs from the assets (housing loans) is used to pay interest and repayment of principle on the ABS or MBS.

Step 1:- The company holding the assets (generally- house loan, car loan, trade receivables, insurance premiums etc.) gather the data on the assets it would like to remove from its balance sheets.

Step 2:- The assets so identified is then sold to a Special purpose entity (SPE) also known as special purpose vehicle (SPV).

Step 3:-The SPV finances the acquisition of the assets by issuing interest bearing bonds to Investors.

Step 4:- The cash flows from the assets is used to pay interest and repayment of principle to Investors.

Securitization acts not only as a means to raise cash but also as a credit risk transfer tools. Transfer of credit risk from issuers (originator) to investors.

Special purpose vehicle (SPV):-

A Special purpose vehicle (SPV) also called Special purpose entity (SPE) is an entity created by a financial institution, Specifically to purchase the assets and isolate the firm's financial risk.

➜ SPV is created as a separate legal entity with its own Assets and Liabilities (balance-sheet).

➜ The SPV is a Bankruptcy remote vehicle, which means if the Originator company become bankrupt, than creditors of the originator company can not have recourse to the asset held by the SPV.

What is Asset Backed Securities (ABS)?

Ans:- Asset backed securities are consolidated financial instruments derived from a pool of loans that are packaged and sold to investors as securities.

➜When a consumer takes out a loan, their loan becomes an asset on the balance-sheet of loan provider. ➜The loan provider, in turn, can sell these assets to a Special purpose entity(SPE), ➜SPE packages them into Asset backed securities (ABS) that can be sold in the public market.

Types of loans generally securitize include:- Mortgages, Credit Card Loans, Students Loan, and Auto Loans.

➜ If securities are issued against mortgages (house loans), it is called mortgaged backed securities. All other loans (other than mortgages) against which any securities are issued called Asset backed securities.

What is Collateralized Debt Obligation (CDO)?

Ans:- Collateralized Debt Obligation (CDO) is a generic name used for securities backed by a diversified portfolio of debt obligations.

➜ if the debt obligations comprises of emerging market or corporate bond, we call it Collateralized Bond Obligation (CBO).

➜ if it comprises of leveraged loan, we call it Collateralized Loan Obligation (CLO).

➜ if it comprises of RMBS, CMBS, ABS, etc., we call it Structured finance CDO.

➜ if it comprises of Certificate of Deposits (CD) written on some reference entities, we call it Synthetic CDO.

In the year 2008, Several major financial institutions like:- Lehman Brother (one of the largest investment bank) was collapsed, with significant disruption in the flow of credit to businesses and consumers and onset of a Global Recession. The crisis was Financed with ABS, MBS and CDOs. 

    DO NOT BLAME THE GUN, BLAME THE SHOOTER.   

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