What it means
A bank or company that makes many loans or has many customer invoices can bundle them together and sell the right to the resulting payments to a separate legal entity, usually called a special purpose vehicle. The vehicle then issues securities to investors, funded by the cash flows from the pool.
This process is called securitisation and is the heart of structured finance. The securities are divided into layers called tranches.
The senior tranche is paid first and takes losses last, so it is the safest and pays the lowest return. Junior and equity tranches absorb losses first and offer higher returns to compensate.
The benefit for the originator is funding and risk transfer. It receives cash today instead of waiting years for borrowers to repay, which frees up capital to lend again, and it moves some credit risk away from its own balance sheet.
For investors, the structure offers access to assets such as car loans, credit card receivables and commercial mortgages that they could not easily buy directly. Credit enhancement protects the senior holders.
This can include subordination, where junior tranches absorb losses first, and over-collateralisation, where the assets exceed the securities issued. Rating agencies assess the structure and assign grades to each tranche.
The 2008 financial crisis showed the risks. Complex structures built from poor-quality mortgages, with ratings that were too generous, made losses hard to trace and spread them widely.
Since then, regulators have required more disclosure and, in many places, that originators keep a share of the risk themselves. For non-specialists, the main lesson is to look through the label to the underlying assets.
The quality of the loans, the order in which losses are absorbed and the legal terms of the structure matter more than the name of the product.
In practice
Real-world examples.
Example
A car finance company holds $500,000,000 of loans and wants to fund new lending. It sells the loans into a vehicle that issues securities in three tranches. The company receives cash immediately and uses it to write new loans.
Example
A retailer's credit card business packages its receivables into securities that pay investors from customers' monthly repayments. Pension funds buy the senior tranche for its steady income. The retailer records the funding and monitors the pool's performance monthly.
Example
A property company owns office buildings and uses structured finance to raise money against the rental income. Investors in the senior notes receive a lower yield and priority claims, while the company retains the equity portion for higher potential returns.
Formula
Calculation
Credit enhancement for a tranche = value of tranches ranking below it / total value of the pool
Suppose a $100,000,000 pool of car loans is split into a senior tranche of $80,000,000, a mezzanine tranche of $15,000,000 and an equity tranche of $5,000,000. The credit enhancement for the senior tranche is (15,000,000 + 5,000,000) / 100,000,000 = 20%. If the pool suffers losses of $4,000,000, the equity tranche absorbs them first and falls from $5,000,000 to $1,000,000, while the senior and mezzanine tranches are unaffected. Losses would have to exceed $20,000,000 before the senior tranche lost anything.Case study
Seen in the real world.
Riverbend Lending is an illustrative, fictional consumer lender that had grown quickly but was running out of funding. Its finance team pooled $200,000,000 of personal loans and sold them into a special purpose vehicle, which issued senior notes of $160,000,000, mezzanine notes of $30,000,000 and equity of $10,000,000.
The senior notes were bought by insurers seeking stable income, the mezzanine notes by specialist funds, and Riverbend kept the equity. The company used the proceeds to fund new loans and reduce its reliance on bank credit lines.
When a downturn raised defaults, losses of about $6,000,000 were absorbed entirely by the equity tranche, which fell from $10,000,000 to $4,000,000, so the mezzanine and senior investors were not affected. The illustrative lesson is that the structure moved the risk to those willing to hold it, but Riverbend itself still bore the first losses.
Watch out
Common mistakes.
- Assuming a high credit rating on a tranche means the underlying loans are safe, when the rating reflects the structure as well as the assets.
- Ignoring the quality of the underlying loans because the product looks sophisticated.
- Believing structured finance removes risk, when it only redistributes it between investors.
Questions
People also ask.
What is the difference between structured finance and ordinary lending?
In ordinary lending the lender holds the loan, while in structured finance the loans are pooled and sold as securities with different risk levels.
Who invests in structured finance products?
Banks, insurers, pension funds and specialist investment funds, with each choosing the tranche that matches their risk appetite.
Why did structured finance have such a bad reputation after 2008?
Complex products were built from weak loans and rated too optimistically, which spread unexpected losses through the financial system.
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