Structured finance is a very broad term, which is used to refer to a sector of finance, which was developed to help in transferring risk with the help of complex legal, as well as corporate entities. Such a risk transfer as useful in securitization of different financial assets, such as credit card receivables, mortgages and auto loans, has helped in opening up new avenues of financing for consumers. However, this has also been believed to contribute to the degradation of the underwriting standards of such financial assets. This helped in the rise to the credit bubble, as well as the credit crash experienced a few years ago.
As it is, securitization is a method which is employed by the participants of structured finance, in order to set up the pools of assets, which are used for the creation of end product financial instruments.
An important concept in terms of structured finance is that of tranching. It is a system, which is used for creating different investment categories for securities, which are created in the arena of structured finance. It helps the cash flow from underlying asset to get diverted to several investor groups. A major objective of the process of tranching is to set up at least a single category of securities with rating higher than an average rating of underlying collateral pool or for creating rated securities from a group of unrated assets. Now, this is done with the usage of credit support, like prioritization of payments in regard to various tranches.
As it is, credit enhancement is a key for creation of a security, which has an elevated rating than an issuing company. Credit enhancement might be created through issuance of subordinate bonds. These bonds are allocated the losses from the collateral prior to losses being allocated to Senior Bonds, thereby giving the senior bonds credit enhancement. Also, several deals, particularly, deals, which involve riskier collateral like subprime collateral, use overcollateralization along with subordination.
In case of over collaterization, the balance of loans is higher than balance of the Bonds, thereby creating extra interest in the deal. The extra interest might be used for offsetting collateral losses before the losses have been allocated to the bondholders thereby providing an additional credit enhancement. As it is, another credit enhancement includes the usage of derivatives like corridors, swap and caps. Apart from that, ratings too play a very important role in case of structured finance.