What's Structured Finance?

Structured finance refers to the design and provision of financial products and services to satisfy complex financial requirements. It covers a wide range of activities and products.

The technique creates tailor-made products to meet the client’s requirements involving funding, liquidity, risk transfer and regulatory needs. Some of the product examples, all of which can be administered within TAO Solutions’ proprietary software solutions falling into the realm of structured finance are asset-backed securities (ABS), residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS).

How Structured Finance Works?

Since the mid-1980s, structured finance has become well recognised and supported by governments and regulatory authorities including the Federal Reserve Bank, European Central Bank, Bank of Canada, Bank of England, Reserve Bank of Australia, Reserve Bank of New Zealand, Central Bank of the Republic of China, Monetary Authority of Singapore, Bank of Japan, Bank of Korea and many more. TAO Solutions provides the technology infrastructure that enables issuers, originators, lenders, trustees and investors to structure, administer and report on these transactions in a controlled, auditable manner.

Securitization (securitisation) is the core of structured finance. It is the method by which those in structured finance create asset pools and ultimately form complex financial instruments that are useful to corporations and investors with special needs. The specific reasons why securitization is valuable include alternative funding formats and a reduction of credit risk via portfolio diversification.

Tranching is then used to create different classes of securities (typically with different credit ratings) from the same pool of assets. Tranching allows the cash flow from the underlying pool of assets to be diverted to various securities (or instruments within TAO’s software). The Bank for International Settlements Committee on the Global Financial System explains tranching as follows: "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."

Credit enhancement is key in creating a security that has a higher rating than the underlying asset pool. Credit enhancement can be created, for example, by issuing subordinated securities. The subordinated securities are allocated any losses from the collateral before losses are allocated to the senior securities, thus giving senior securities structural credit enhancement. Over-collateralization is also used whereby the balance of the underlying assets is greater than the balance of the outstanding debt, thus creating excess interest in the deal which acts as a "cushion" against reduction in value of the underlying assets. Excess interest income can be used to offset collateral losses before losses are allocated to noteholders, thus providing another credit enhancement. 

TAO Solutions uses its proprietary software solutions to undertake financial modeling of structured finance transactions, including the pooling of assets, the tranching of financial assets and the required credit enhancements and trigger events. It does this in a manner that is auditable, controlled and introduces industry best practices.

Benefits of Structured Finance

Structured financing and securitization are used by corporations, governments, and the financial services industry to manage risk, obtain alternative sources of funding, achieve lower costs of funding and develop financial markets. TAO Solutions software can be used by these market participants to automate the administration of structured finance activities and the interaction between the various market participants.

Securitization is the process through which a pool of financial assets, such as loans or receivables, is combined and converted into tradeable securities that are sold to investors. Like structured finance more broadly, securitization promotes liquidity, provides a more cost-effective source of funding and supports more efficient use of capital.

The types of structured finance transactions supported by TAO Solutions software include:

• Asset-backed securities (ABS) represent pools of assets that are collateralized by the cash flows from a defined pool of underlying assets, such as auto loans, credit card receivables or equipment leases.
• Mortgage-backed securities (MBS) are backed by the principal and interest payments from a pool of mortgage loans.
• Residential mortgage-backed securities (RMBS) are backed by mortgages on residential properties, typically single-family homes and apartments, both owner-occupied and held for investment (buy-to-let) purposes.
• Commercial mortgage-backed securities (CMBS) are backed by loans secured against commercial properties, such as shopping centres or office complexes.
• Commercial real estate collateralized debt obligations (CRE CDOs) are collateralized debt obligations backed primarily by commercial real estate loans.