A new trend to get project and products financed is expanding like lit powder everywhere. It follows the same principles as crowdfunding. They are financial tools for those investors that seek to secure quick acquisition of capital and promptly payouts.
Structured finance involves a lot of complexities related to the business world. As a financial tool we can say corporate structured finance has been designed to serve high powered borrowers in need of high sums of cash flow. It is the type of money that even a loan from a bank cannot cover, and although risky, is very profitable. It’s why it is so sought after by people looking to make quick money out of their savings.
The easiest way to explain how structured finances work goes like this: A financial institution or a project manager requires a large sum of money to financed by a third party. This is to manage the cost of operational needs related to the said project. It can be in the form of a real estate development or the buyout of a company. The problem is that the sum of money required by the potential lender is too great and no bank can cover it on its own.
With structured finance, the borrower can gather money from many sources at once. This is done by using derivatives as well as securitized, and collateralized financial debt tools. These tools include collateralized mortgages, syndicated loans, collateralized bonds (CBOs), credit default swaps (CDSs), collateralized debt (CDOs), and hybrid securities. These financial products are not offered regularly offered, and require special agencies.
The first thing we noticed is the possibility of securitization. With this tool, the participants of these schemes gather many assets. They will be used as the figure of collateral in the creation of the final financial instruments.
The best reasons to use securitization are centered behind three reasons. It improves the use of the financing capital available. It is also a source of alternative funding and a cheaper option to low-rated originators. It’s also helpful to reduce credit concentration and risk manages interest rates. Liquidity becomes the norm with minimal risk transfers.
The other feature is tranching. It is a fancy way to handle the creation of securities in different classes. It is arranged according to their credit rating using a single pool of assets. It’s a versatile system used to create diverse investment classes for the securities available. Tranching allows the cash flow from all the underlying assets to be used amongst the investor groups. This feature is a door to create one class of securities with a higher rating than the average setting of the underlying collateral pool. It also pursues the creation of rated securities from a pool of unrated assets.
Finally, structured finances promotes credit enhancement. This is critical in the creation of security rated higher than the underlying asset pool. Credit enhancement can be created by issuing a series of bonds. These bonds are allocated to cover any losses from the collateral before the losses are assigned to the senior bonds. From this way, these bonds get a credit enhancement. The final result is a potential default that could take place as repayment of the underlying assets.
This is no way affects the payments to holders of the senior bonds. Excessive interest in a project can be used to offset the collateral losses of the project. This can be done before said losses are allocated to bondholders. In this way we can provide some credit enhancement. All the credit enhancement involves the use of derivatives such as swap transactions. These will effectively provide insurance against a decrease in value for a price.
In Australian structured finance, investors place assets into the pool of mortgages. Each of these investors have an equal claim to mortgage payments. This means that the expected losses for lack of security will be the same as the basic default rate of the mortgages.
All this can be very confusing. The main factor you need to understand is money and assets in the form of property are required to enter the world of structured finances.
The financial tool is flexible. However, it has one drawback. Lenders’ assets are not transferable for other types of debt in the same way a straightforward loan works. This means that you are stuck with your options until the very end. Remember that most of the mortgages are not correlated under the default probabilities.