The financial market has a range of products widely available for individuals and businesses seeking finances for a transaction. The normal types of financial instruments such as overdrafts, loans and mortgages serve the needs of the majority of customers. However, some borrowers have unique needs that cannot be met through conventional products. For them, the use of unique arrangements that belong in the category of structured financing is necessary.
Borrowers who rely on structured financing tend to be huge corporations whose needs exceed what a simple loan can offer. In many cases, structured finance requires the completion of other optional transactions that require the implementation of risky instruments. Many of these transactions require an injection of significant capital into a business, thereby requiring investors. In most situations, structured financing deals are non-transferable.
Derivatives and collateralised debt instruments such as syndicated loans, collateralised bond obligations (CBOs), credit default swaps (CDSs), hybrid securities, collateralised debt obligations (CDOs) and collateralised mortgage obligations make up the products offered through this mode of financing. For major entities, the use of these products helps to manage risks, expand business reach, and come up with funding that helps navigate emerging markets. It also helps to transfer risk to buyers of the products.
Structured financing, though complex, is common in many markets around the world. From entities to interested individuals such as Domen Zavrl, this aspect of financing provides multiple opportunities for both major corporates and buyers.
The Growth of Asset-backed Securities
Securitization refers to the process of packaging non-tradeable assets into a financial instrument that can be offered to investors. These instruments help to increase liquidity in the market, and for their part, investors receive interest. A company offering mortgage-backed securities (MBS), for example, will pool together mortgages before assessing the risk levels and payment default chances to create smaller pools. These smaller pools, or tranches, are then offered to investors who can choose to participate based on their risk appetite and due diligence on the tiers of the repackaged product.
Through this process, retail investors can buy shares in financial instruments that would typically be unavailable. For example, a small investor can purchase an MBS that provides regular interest returns and principal payments, something that would not be possible if they were asked to buy into a large pool of mortgages.
The loan-based securities created through securitization are backed by actual goods that can be liquidated (in the event of default) to compensate those who have bought into the debt. Additionally, the originator of the security (the company holding the assets) uses securitization to reduce its liabilities on the balance sheet, opening up the opportunity to underwrite more loans.
However, there are drawbacks to this process. First, even with tangible assets to back up the securities, it doesn’t help much if the loan holders default on payment and the sale of assets doesn’t recoup much value. Second, transparency regarding the underlying assets can be an issue, especially where the packaged securities are misrepresented to investors. Third, if the loan holders pay off their debt early, an investor's returns from interest reduce.
Understanding Asset-Backed Securities
As the securitized financial products are sold in tranches – portions that have varying risks, maturities and rewards – investors have to be smart when investing in them. Those who desire to enjoy steady cash flow for the long-term will invest in tranches with longer maturity periods, whereas those who want to enjoy lucrative, but more immediate rewards will go for those with shorter maturities.
Regardless of the maturity and interest offered, tranches provide financial institutions with opportunities to attract investors with different needs. To investors, tranches are a means of catering to a specific need within their overall strategy. However, if an investor is uninformed on the intricacies of debt investing, they might end up putting their money in something that doesn’t meet their goals.
