Structured finance is an investment option for major financial institutions with complex financing needs. This vehicle enables banks to access significant capital funding to respond to emergencies or crises in their industry.
Banks needing substantial financing pool resources into various asset classes to attract lenders. They create packages comprising loans, mortgages, and bonds and categorize them based on risk levels. Lenders assess the products to choose the ones fitting their risk tolerance and provide funds to the bank in return.
Like traditional financing, structured financing is subject to defaults from the initial borrowers. Loanees can be divided into those with a high risk of default and those who are most likely to pay. Banks offer high-interest rates on packages comprising loans with an increased risk of default and low-interest rates on low-risk loans. In both cases, lenders retain the initial borrower's collaterals as security.
Lenders evaluate the borrower's cashflows before financing. Those with a history of steady cashflows in their books are legible of structured funding. Furthermore, lenders assess the banks' illiquid assets to determine if they can convert them into liquid assets. If this is possible, lenders can provide more funding to the banks to meet their needs.
Structured products are beneficial to lenders since they promote diversification. Investors purchase products that combine multiple assets, which minimizes the risk of underperformance from a single investment. Moreover, these products offer principal protection, tax efficiency, and low volatility. However, unlike conventional products, structured products are non-transferable, meaning lenders cannot convert them into other types of debts.
Collateralized debt obligations (CDOs) and collateralized bond obligations (CBOs) are examples of structured products. CDOs comprise various loans that banks bundle together to attract lenders.
Lenders receive periodic interest payments from the initial borrowers. At the end of the tenor, the investors also receive the capital loan amount. Banks subdivide CDOs into tranches reflecting their underlying risk levels. After successful repayment by the initial borrowers, financial institutions repay senior debts first, and then the rest receive their money based on their investments' security levels.
CDOs help banks reduce risks in their balance sheet by transferring the risk of underlying assets to the investors. Additionally, financial institutions can expand their borrowing capacities by converting their illiquid assets into liquid resources to fund their projects. CDOs also support banks' utilization of emerging markets by promptly attracting major capital injections. This move can help borrowers develop a competitive edge and first-mover advantage ahead of other banks.
On the other hand, CBOs are packages that combine multiple junk bonds. Lenders pool bonds with a high likelihood of default and offer them to investors in exchange for funding. Banks and organizations facing financial troubles provide this product to serve their financing interests. Similar to CDOs, banks offer CBOs in tranches reflecting their risk levels.
Moreover, investors receive annual coupon rates and the principal bond amount after maturity. However, lenders prefer investing in CBOs over CDOs because they are overcollateralized. This means that the collaterals backing these products are more valuable than the amount banks borrow. This attribute guarantees investors they will receive their money even after defaults.
Lenders also benefit from CDOs because they have a higher return on investment (ROI) than other fixed-income debt securities. The junk bonds in these products mean banks pay high-interest rates to investors as motivation for funding. Lastly, lenders can benefit from this investment in case the borrower's finances improve in the future. In this case, the bonds' value improves to raise the investors' ROI.
