The only and true way to
use debt is to structure it:
BY MELVIN J. HOWARD
Structured finance
encompasses all advanced private and public financial arrangements that serve
to efficiently refinance and hedge any profitable economic activity beyond the
scope of conventional forms of on-balance sheet securities (debt, bonds,
equity) at lower capital cost and agency costs from market impediments on
liquidity. In particular, most structured investments combine traditional asset
classes with contingent claims, such as risk transfer derivatives and/or
derivative claims on commodities, currencies or receivables from other reference
assets, or replicate traditional asset classes through securitization or new
financial instruments. Structured finance is invoked by financial and
non-financial institutions in both banking and capital markets if established
forms of external finance are either unavailable (or depleted) for a particular
financing need, or traditional sources of funds are too expensive for issuers
to mobilize sufficient funds for what would otherwise be an unattractive
investment based on the issuer’s desired cost of capital. Structured finance
offers the issuers’ enormous flexibility in terms of maturity structure,
security design and asset types, which allows issuers to provide enhanced
return at a customized degree of diversification commensurate to an individual
investor’s appetite for risk. Hence, structured finance contributes to a more
complete capital market by offering any mean-variance trade-off along the
efficient frontier of optimal diversification at lower transaction cost.
However, the increasing complexity of the structured finance market, and the
ever growing range of products being made available to investors, invariably
create challenges in terms of efficient assembly, management and dissemination
of information.
The premier form of
structured finance is capital market-based risk transfer (except loan sales,
asset swaps and natural hedges through bond trading whose two major asset
classes include asset securitization (which is mostly used for funding
purposes) and credit derivative transactions (as hedging instruments) permit
issuers to devise almost an infinite number of ways to combine various asset
classes in order to both transfer asset risk between banks, insurance
companies, other money managers and non-financial investors in order to achieve
greater transformation and diversification of risk.
Asset securitization
describes the process and the result of converting a pool of designated
financial assets into tradable liability and equity obligations as contingent
claims backed by identifiable cash flows from the credit and payment
performance of these asset exposures. Asset securitization initially started as
a way of depository institutions, non-bank finance companies and other
corporations to explore new sources of asset funding either through moving assets
off their balance sheet or raising cash by borrowing against balance sheet
assets (“liquifying”) without increasing the capital base (capital
optimization). In the meantime, securitization has gone a long way in advancing
further objectives beyond being a flexible and efficient source of funding.
For issuers,
securitization registers as an alternative, market-based source of refinancing
economic activity in lieu of intermediated debt finance. Securitization
substitutes capital market-based finance for credit finance by sponsoring
financial relationships without the lending and deposit-taking capabilities of
banks (disintermediation). The off-balance sheet treatment of securitization
also serves to reduce both economic cost of capital and regulatory minimum
capital requirements as a balance sheet restructuring tool (regulatory and
economic motive) and to diversify asset exposures (especially interest rate
risk and currency risk). The generation of securitized cash flows from a
diversified asset portfolio also represents an effective method of
redistributing asset risks to investors and broader capital markets
(transformation and fragmentation of asset exposures). The implicit risk
transfer of securitization does not help issuers improve their capital management,
but also allows issuers to benefit from enhanced liquidity and more cost
efficient terms of high-credit quality finance without increasing their
on-balance sheet liabilities or compromising the profit-generating capacity of
assets. However, securitization involves a complex structured finance
technology, which commands significant initial investment of managerial and
financial resources.
Investors in
securitization have a wider choice of high-quality investments at their
disposal, whose market valuation engenders greater overall efficiency and
liquidity of capital markets. The tradability of securitized asset risk also
facilitates the synthetic assembly and dynamic adjustment of asset portfolios
via secondary markets according to investor preferences. As opposed to ordinary
debt, a securitized contingent claim on a promised portfolio performance
affords investors to quickly adjust their investment holdings at low
transaction costs in response to changes in personal risk sensitivity, market
sentiment and/or consumption preferences.
