Structured finance one of the part which comes under the finance sector where the risk factor is transferred using the legal channels as well as the corporate entities. This process was developed specifically for this purpose. The benefit which this process has brought into the financial market is that the different financial assets like credit receivables, auto loans and mortgage have been secured. The clients in the financial market therefore have been benefited has opened up more providing more choice to the ultimate customers in the market. While these lines till now gives the market a shine of gold there are some dark clouds too that roll in with such process. The underwriting process of financial assets, reaches an all time low, is one such ill effect. There is also the probability of rapid rise of the credit bubble which could mean a violent crash to follow soon. For this reason, securitization process is always used by those who indulge in structured financial procedures. Using this, individuals would create the asset pools which in turn would be used for creating the end product of the financial instrument.
Tranching and structured finance
Another very crucial and important concept applied to structured finance is tranching. Using this concept, varied categories of investment is created thereby extending a higher level of security from financial risks. Cash from the underlying asset gets diverted to different investor groups, by the help of Tranching. To understand the underlying channel of Tranching, issues like credit support and its usage has to be understood and applied.
Credit enhancement and security
It is well accepted that credit enhancement is one, and the major issue which helps to create the security cover which essential to function in the financial market. One way to increase credit or cash flow into an asset is by issuing subordinate bonds. Losses from the collateral are allotted to the credit prior to the losses being allocated to Senior Bonds. What happens in the process is that the Senior Bonds receive credit enhancement. The deals that need to indulge in more risk collateral like subprime collateral would use a subordination process in conjunction with over collateralization. Extra interest in the deal is created as the collateralization creates a higher balance of loans than the balance of the Bonds. The accrued extra interest can then be used to offset collateral losses before allotting to bond holders. The Bond holders thereby receive added credit enhancement. Another factor which plays an important part in credit enhancement are swap and caps as well as derivatives. Ratings are another aspect of structured finance that has an important role to play.
The Bottom Line
As mentioned earlier, structured finance is an innovative tool that has been created in the financial market. Spreading risk while lowering equity thresholds makes this tool a very attractive one for application in the financial market. It is the use of this tool that had helped in inflating the Great Housing Bubble. Capital market can be given a rapid and secure boost if this tool is used judiciously. However, there is the danger of the capitalist system turning into a financial destitute if this same tool is used inappropriately.