First coming to prominence in the mid-1980s, structured finance is a financial instrument traditionally utilized by large corporations or institutions unable to meet their needs through conventional financial products. Structured finance spans synthetic financial instruments, collateralized debt obligations (CDOs), credit-linked notes, asset-backed securities, and syndicated loans throughout the finance industry. It's used in developing financial markets and managing risk across complex emerging markets.
Securitization is at the foundation of structured finance, a method by which existing non-financial assets are pooled and created to create complex financial instruments. Promoting liquidity, these repackaged instruments are sold to investors as tradable financial products in tiers that reflect sectoral and risk-reward dynamics.
A classic security is the stock. While the stock certificate represents a company's share, its value is not tangible and set. Instead, it depends on what people on the open market think it's worth. Structured finance securities have a similar underlying value, though not limited to shares of a company. Instead, they can be any asset that holds financial value. The most common type of asset is debt, which includes bundled financial obligations such as student loans, mortgages, and consumer holdings.
For example, a bank creates a mortgage-backed security that combines many mortgages under one umbrella. Once they are grouped in a pool, the issuer can divide the pool into pieces allocated based on the risk of default and sold to investors at a price that reflects these risks. Cash flow has now been channeled in new directions, and existing risk has been spread across many investors.
The roots of structured finance lie in economic downturn, oil shocks, and rapid interest rate increases of the late 1970s and early 1980s. With the unstable global outlook, major financial institutions required additional protection. By the 1990s, credit derivatives had been formalized into dozens of distinct structured products, such as asset swaps, total return swaps, and credit default swaps (CDS).
The latter are financial derivatives that enable investors to offset or swap credit risks. The credit exposure represented by fixed-income products is purchased by a buyer on an ongoing premium basis, as with insurance policies. In return, sellers agree to pay the security's value and interest payments should a default occur. Swaps had a major role in easing the Great Recession of 2008 and the European Sovereign Debt Crisis of 2010. The scope of credit swaps is extremely large, with the CDS market in the US alone estimated at $4.3 trillion.
Beyond risk management, structured finance enables tailored cash flow structures and payment priorities in ways that reflect the specific requirements of borrowers. With a wide range of asset classes covered by structured products, portfolios gain diversification, which is essential in times of downward stock market movements.
In recent years, one change in structured finance markets is the emergence of new segments of issuers and purchasers. While traditionally, those products that offered secured investments and reasonable returns were the exclusive province of individuals of very high net worth and major institutions, they are now available to a broad range of investors. Those with diverse objectives and risk-reward profiles can now participate in the markets, which offer issuers flexibility regarding security type, asset type, and maturity structure.
