Structured finance is invoked by financial and non-financial institutions in both banking and capital markets if established forms of external finance are either (i) unavailable (or depleted) for a particular financing need, or (ii) traditional sources of funds are too expensive for issuers to mobilize sufficient fund for what would otherwise be an unattractive investment based on the issuer’s desired cost of capital. Structured finance offers the issuers enormous flexibility in terms of maturity structure, security design and asset types, which allows issuers to provide enhanced return at a customized degree of diversification commensurate to an individual investor’s appetite for risk. Hence, structured finance contributes to a more complete capital market by offering any mean-variance trade-off along the efficient frontier of optimal diversification at lower transaction cost. However, the increasing complexity of the structured finance market, and the ever growing range of products being made available to investors, invariably create challenges in terms of efficient assembly, management and dissemination of information.
The premier form of structured finance is capital market-based risk transfer (except loan sales, asset swaps and natural hedges through bond trading, whose two major asset classes include asset securitization (which is mostly used for funding purposes) and credit derivative transactions (as hedging instruments) permit issuers to devise almost an infinite number of ways to combine various asset classes in order to both transfer asset risk between banks, insurance companies, other money managers and non-financial investors in order to achieve greater transformation and diversification of risk.
Securitization seeks to substitute capital market-based finance for credit finance by sponsoring financial relationships without the lending and deposit-taking capabilities of banks (disintermediation). The issuer raises funds by issuing certificates of ownership as pledge against existing or future cash flows from an investment pool of financial assets in the bid to increase the issuer’s liquidity position without increasing the capital base or by selling these reference assets to a SPV, which subsequently issues debt to investors to fund the purchase.
Aside from being a flexible and efficient source of funding, the off-balance sheet treatment of securitization also serves (i) to reduce both economic cost of capital and regulatory minimum capital requirements as a balance sheet restructuring tool (regulatory and economic motive) and (ii) to diversify asset exposures (especially interest rate risk and currency risk) (Jobst, 2005b). The generation of securitized cash flows from a diversified asset portfolio represents an effective method of redistributing asset risks to investors and broader capital markets (transformation and fragmentation of asset exposures). As opposed to ordinary debt, a securitized contingent claim on a promised portfolio performance affords investors at low transaction costs to quickly adjust their investment holdings due to changes in personal risk sensitivity, market sentiment and/or consumption preferences.
Overview of risk transfer instruments (Jobst, 2005a, and Effenberger, 2003).
Credit derivatives are financial instruments that isolate and transfer credit risk. As a common working principle derivatives involve the sale of contingent credit protection for pre-defined credit events of lending transactions. In their basic concept, credit derivatives sever the link between the loan origination and associated credit risk, but leave the original borrower-creditor relationship intact. The protection buyer of a credit derivative hedges specific credit risk in return for periodic premium payments to the protection seller, who assumes the credit exposure of a financial contract isolated from the underlying transaction.
1 The significance of credit derivatives lies less in their market share next to other derivative instruments (e.g. interest rate and foreign exchange derivatives) but in their ability to supplement traditional ways of hedging credit risk through the transfer of credit-related exposures to a third party. Other non-credit derivative based forms of credit risk transfer include credit insurance, syndicated loans, loan sales, bond trading and asset swaps. We distinguish between credit derivatives in the narrower and in a wider sense. The latter classification includes pure credit derivatives, such as credit default swaps (CDSs), total return swaps and credit spread options, as well as hybrid products and securitization products with credit derivative elements, such as collateralized debt obligations (CDOs) of bonds and loans. Some unfunded/partially funded structured finance transactions, such as credit-linked notes (CLNs) and synthetic CDOs are credit derivative-based securitization transactions
2 that provide refinancing through cash flow restructuring and tranche-specific credit risk transfer.
3 These hybrid products, which are considered credit derivatives in a wider sense, usually condition the repayment of securitized debt on a defined credit event in a bilateral hedge (in the case of CLNs), the premium income generated from credit protection sold on reference assets (in the case of synthetic CDOs), or the returns from investing and/or writing credit protection on securitization transactions as constituent assets of a diversified pool of CDOs and/or ABSs(“pools of pools”). CDOs have been the fastest growing area of structured finance. Generally, a CDO represents a form of assetbacked securitization (ABS), which converts a large, diversified pool of exposures into tradable capital market debt instruments (tranches). In a CDO structure asset managers can increase assets under management while locking in committed funds and achieving some protection from market value volatility. While cash CDOs are backed by a collateral of actual bonds and loans as reference assets, whose legal title is transferred to the purchaser, issuers of synthetic CDOs enlist wads of credit derivatives and various third-party guarantees to
1 In a cash-settled CDS, the protection seller is required to make a settlement payment in the amount of the difference between the notional principal and the market price of the bond or the reduced recovery value of the defaulted bank credit. Alternatively, in what has increasingly become the market norm, in physical settlement CDSs the protection seller receives the reference assets against payment of their par value. Unlike credit insurance contracts, credit derivatives are negotiable and attract large secondary trading.
2 This feature does not apply to plain vanilla asset-backed securities (ABS) and mortgage-backed securities (MBS).
3 Note that despite the transformation and fragmentation of credit risk through securitisation brings greater diversification within the financial system, the structural complexity arising from multi-layered security designs, diverse amortisation schedules and the state-contingent funding of synthetic credit risk transfer might obfuscate actual riskiness of these investments and inhibits provident investment. The tradability of credit risk facilitates the synthetic assembly and dynamic adjustment of credit portfolios via secondary markets, but numerous counterparty links established in the commoditisation of securitised asset risk also create systemic dependence susceptible to contagion. This prospect of leveraged investment in synthetic structures seems to be particularly troubling when investors take on more risks for yield during times of compressed spreads and rising default rates when credit cycles approach their turning-point. Moreover, the contingent liability of credit derivatives as credit protection of securitised assets requires the protection seller to put up liquidity only if a credit event occurs. create partially funded and highly leverage investment from synthetic claims on the performance of designated credit exposures (Shepherd, 2005). CDOs involve either cash flow or arbitrage mechanisms to either fund expected principal and interest payments or expected trading and sales activity. CDOs enable issuers to achieve a broad range of financial goals, which include the off-balance sheet treatment of securitized exposures, reduced minimum regulatory capital requirements and access to alternative sources for asset funding and liquidity support. The conventional security design of CDOs assumes a typical three-tier securitization structure of junior, mezzanine and senior tranches, which concentrates expected losses in a small first loss position as equity claim, which bears the majority of the credit exposure and is frequently covered by a junior CDS, shifting most unexpected risk to larger, more senior tranches, which display distinctly different risk profiles. This risk sharing arrangement induces a leverage effect on constituent tranches, whose distinct risk-return profiles can be tailored to specific investment preferences.
