Structured finance is a complex form of financial engineering that is primarily used to manage risk and increase liquidity. It involves the pooling of financial assets and the subsequent creation of securities that are repackaged and sold to investors. This financial strategy is especially useful for large institutions, corporations, and governments looking for innovative ways to raise capital, transfer risk, and improve cash flow.
Securitization:
This is the backbone of structured finance. It involves pooling various financial assets and then issuing new securities backed by these pools. For example, a bank may pool together a portfolio of home loans and sell them as mortgage-backed securities to investors. This allows the bank to remove these loans from its balance sheet, reducing risk and freeing up capital.
Tranching:
Tranching is a risk management tool used in structured finance. The pooled assets are divided into different tranches based on their risk level and expected returns. Senior tranches carry lower risk and offer lower returns, while junior tranches carry higher risk but offer higher potential rewards. Investors can choose the tranche that best matches their risk appetite.
Credit Enhancement:
To attract investors, structured finance products often include credit enhancement strategies that improve the credit profile of the securities. This could be done through over-collateralization, insurance, or third-party guarantees, which provide a safety net in case the underlying assets underperform.
