Structured Finance

Structured Finance

Structured financing refers to various typical methods of raising money, in particular, standard loans, debentures, debt or equity. Some structures are based on exploiting taxation laws or tax differences between States so as to create deductions that might not otherwise be available or convert non-tax deductible expenses in the tax-deductible expenses or taxable income into non-taxable income.

Structured finance has developed with the greater integration of financial markets and increasing complexity. Structured finance embraces a wide range of measures and techniques.  It may include public, private finance, complex syndicated loans.  It may involve the use of derivatives.

Securitisation

Securitisation involves the packaging of pools of loans and other receivables into securities.  There may be an element of credit enhancement.  The securities are then repackaged and sold to investors.

Securitisation was criticised as a factor which aggravated the financial crisis.  It was claimed to be complex and opaque.

Although promoted on the basis of spreading the risk, its effect was to diffuse certain types of risks which were not readily apparent through the international financial system most notoriously by packaging very low quality subprime mortgages and distributing them through the financial system, causing widespread disruption at the outset of the financial crisis.  The presence or suspected presence of such assets on the balance sheet of financial institutions was a significant factor in the drawing up of the interbank market in autumn 2008.

S.11o Companies

Section 110 of the Taxes Consolidation Act provides for a tax status, which allows enhanced deductibility of expenses in financial transactions.  This status can be an efficient mechanism for securitisation.

Special purpose vehicles are usually established by private companies.  They may be established as public companies if they offer securities to the public. The company may be an entity, to which assets are transferred, including for example, credit receivables such as residential mortgage loans, commercial loans, credit card receivables, car loans etc.

The assets are originated by the original financial institution or public body e.g. a bank, governmental institution, insurance company etc.(the originator).  They typically comprise a large class of the same type of loan receivables.  Prior to the financial crisis, it was thought that statistical trends could show the likelihood of future performance and defaults.  This was used as a basis of modelling the value of the receivables within the SPV.

SPV Structure

The SPV finances itself by issuing securities i.e. shares, notes, equities into the international capital market.  Securities may range from short-term debt of one to two years, to bonds and other forms of longer term debt security.

Legal title to the loans are not generally transferred to the SPVs, and they are usually maintained by the originator on its books.  Accordingly, as regards the customer, the loans and mortgages etc. appear to be owned by it.

A  challenge in the High Court to the ability of the originator to collect loans has been rejected on the basis that legal title to the loans, mortgages etc. were retained by the originator.  The fact that the originator disposes of its beneficial interest in the loans by way of securitisation is irrelevant for this purpose.

Generally, the originator services the loans on behalf of the SPV and uses the proceeds to pay the principal and interest on the notes and other securities and borrowings of the SPV.

In order to improve the risk profile there may be so called credit enhancements.  This improves the credit profile of the underlying assets.  It may be in the form of a guarantee, bond or over collateralisation.

The SPV may also enter facilities to ensure that it has sufficient liquidity to pay principal and interest when due.  The loan notes are secured on the underlying receivables by way of a fixed and floating charge for the benefit of the note holder.

Theory of Securitisation

The effect of securitisation is to repackage credit into securities (interests in a corporate entity).  This allows it to be transmitted through the financial systems.  It frees up lenders to make further lending as they have effectively sold their loans and receivables.

It was assumed that as securitisation was based on the underlying asset pool, perhaps and commonly enhanced, it may have a higher credit rating.  It emerged however in the financial crisis that the effect of defaults in the underlying loan pool was far more than marginal and had a knock-on effect, collapsing the value of many such funds and securities entirely.

The supposed value of the higher credit rating was that originators were able to acquire and sell off loans with higher credit ratings than the originator itself, who might be undertaking a wider range of activities. The originator was enabled to issue fresh loans with the funds received from the proceeds of securitisation.  It also allowed the originators to borrow at cheaper rates than they would otherwise have been able to do so on the basis of the perceived asset strength of the pool.

Securitisation enabled the originators to improve its balance sheet by conversion of its loan portfolio into cash which in turn enabled them to expand its lending by improvement of its debt-equity ratio, while maintaining profitability and the customer relationship. The originator typically plays the role of administrator and obtains fee income.

The effect of securitisation is to provide intermediation between the lender’s own obligations, which are typically short, either by way of deposits, short-term bonds, other interbank loans or short-term lending and its assets which were in the nature of longer-term credit, perhaps extending over 10 to 20 years (albeit that statistically most would be redeemed within 10 years). Securitisation in effect allowed lenders to tap international capital markets.

From the investor’s perspective, it was thought in principle that securities could be structured in a way so as to lower risk. Provision was made for tiered rights, the theory being that the higher rate obligations would have very low risk.  In practice, when the financial crisis emerged, there was much greater contagion between the tiers than had been anticipated.

Securitisation allows for creation of securities which are tailored to requirements of investors.  They may range from securities that are relatively high risk or low risk.  It allows investors to be exposed to the credit market.

Securitised Assets

A wide range of assets have been securitised.  A range of securitisation has been undertaken by financial institutions and large-scale commodities and industrial entities.  Residential and commercial mortgage-backed securities involve portfolios of loan receivables.  The receivables are transferred to the SPV, and the notes are collateralised against the underlying real estate mortgages.

Asset backed securities comprise revenue streams from particular types of loan, for example, car loans, credit card loans.  Commercial asset-backed securities involve packages of commercial loans.  Collateralised debt obligations involve the issue of tiered capital.  Capital is issued which has different tranches or rights, ranging from same senior, mezzanine to subordinated notes.

The most senior notes were assumed to have the minimum risk, with the subordinated junior notes having the greater risk.  Accordingly, the lower risk tranches would have a lower interest rate corresponding with the lower risk, while the higher risk would carry potentially greater return.