The term 'Structured Finance' is included in the Banking edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Choose your edition here...
Structured Finance refers to the possibility of and procedures for issuing loans because of a reliable history of strong corporate cash flow. Instead of using assets for a loan’s collateral, the funds are given out based upon the past history that shows a consistent cash flow in the business of the borrower. This cash flow will provide for the orderly and on- time pay back of the loan principle and interest. This type of financing is usually opted for when the more traditional methods either fail or are simply not practically available to a business.
It is also fair to say that structured finance proves to be an intricately involved and even complex financial instrument. This vehicle permits big companies and financial institutions such as banks to access complicated means for financing their needs. Such needs often will not be good matches for traditional financial products.
This structured finance has grown dramatically from the middle of the 1980s decade. It has evolved and expanded since then to be a significant player in the financial universe. Classic examples of such finance are CDOs collateralized debt obligations, CBOs collateralized bond obligations, synthetic financial instruments, and syndicated loans. Alongside CBOs and CDOs, there are also fairly new instruments like CMOs collateralized mortgage obligations, CDSs credit default swaps, and even hybrid forms of securities which may involve elements of both equity and debt instruments.
In fact it is most often corporations which find themselves in need of this structured finance funding. Many times they discover that a typical loan or even conventional instrument of finance (like corporate bonds) simply will not adequately meet their needs. Sometimes this is because the transaction needs to be discretionary and discreet. In order to accomplish this, creative solutions utilizing riskier instruments are employed.
The reality is that traditional types of lenders do not commonly offer such structured finance solutions and products. It is often up to investors to come up with the major cash infusions for organizations or businesses when such financing is required. Another interesting feature of these products is that they usually can not be transferred. This simply means that they can not be altered from one form of debt to another as with a standard loan.
On an increasing basis and frequency, governments, corporations, and financial intermediary organizations utilize such structured finance securitization programs. They are often deploying these to help manage risk, expand their reach of the business, develop one or more financial markets, or create new means of funding projects. In such scenarios, employing structured finance turns cash flows into lump sum payments. It also has the side effect and consequence of changing the liquidity of financial books and portfolios.
It is the process of securitization that actually creates these complex financial instruments. The magic of this process is that it creatively combines various financial instruments and assets into a single package. These repackaged instruments are rated according to a few tiers. The tiers then get sold on to investors. The advantage to this is that it encourages and fosters liquidity in markets and for businesses.
A typical example of the process of securitization is the MBS Mortgage backed security. When individual mortgages are grouped into a single pool, the issuer gains the ability to break up the large pool into various component pieces. They do this according to their risk of default. Smaller pieces can be sold off to investors, often for a better and more advantageous price by parts than the whole pool would fetch alone.
Utilizing structured finance is often appealing to a company that may lack significant physical assets which they can pledge as collateral. Yet they may possess a substantial base of clients as well as a documented, consistent history of both billing to and payments from their customers. Many times investors will loan money to these kinds of corporations. This is often true even if the companies are small. Investors will generally loan the company money on this basis for a better interest rate than a traditional bank loan would cost the firm to obtain. It also is a faster process with less administrative paper work than a typical business loan from a bank.