Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However, it arguably contributed to the degradation in underwriting standards for these financial assets, which helped give rise to both the credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.
Securitization is the method utilized by participants of structured finance to create the pools of assets that are used in the creation of the end product financial instruments.
Tranching is an important concept in structured finance because it is the system used to create different investment classes for the securities that are created in the structured finance world. Tranching allows the cash flow from the underlying asset to be diverted to the various investor groups. The Committee on the Global Financial System explained tranching succinctly: Ã¢â‚¬Å“A key goal of the tranching process is to create at least one class of securities whose rating is higher than the average rating of the underlying collateral pool or to create rated securities from a pool of unrated assets. This is accomplished through the use of credit support (enhancement), such as prioritization of payments to the different tranches.Ã¢â‚¬Â
Credit enhancement is a key in creating a security that has a higher rating than the issuing company. Credit enhancement can be created by issuing subordinate bonds. The subordinate bonds are allocated any losses from the collateral before losses are allocated to the Senior Bonds, thus giving senior bonds a credit enhancement. Also, many deals, typically deals involving riskier collateral such as subprime and Alt-A, use overcollateralization as well as subordination. In Overcollateralization, the balance of the Loans is greater than the balance of the Bonds, thus creating excess interest in the deal. Excess interest can be used to offset collateral losses before losses are allocated to Bondholders thus providing another added credit enhancement. Another credit enhancement involves the use of derivatives such as swap.