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What is 'Structured Finance'

Structured finance is a highly involved financial instrument offered to large financial institutions or companies that have complex financing needs that don't match with conventional financial products.

Since the mid-1980s, structured finance has become a substantial space in the financial industry. Collateralized debt obligations (CDOs), synthetic financial instruments, collateralized bond obligations (CBOs) and syndicated loans are all examples of structured finance instruments.

BREAKING DOWN 'Structured Finance'

Structured finance is typically indicated for borrowers – mostly extensive corporations – that have unique or highly specified needs that a simple loan or other type of conventional financial instrument will not satisfy. In most cases, structured finance involves one or several discretionary transactions to be completed and thus evolved and often risky instruments must be implemented.

Significance and Benefits of Structured Finance

Structured financial products are typically not offered by traditional lenders. Generally, because structured finance is required for major capital injection into a business or organization, investors are required to provide such financing. Structured financial products are almost always non-transferrable, meaning that they cannot be transferred between various types of debt in the same way that a standard loan is.

Increasingly, structured financing and securitization are used by corporations, governments and financial intermediaries in advancing, evolving and complex emerging markets to manage risk, develop financial markets, expand business reach and design new funding instruments. For these entities, using structured financing transforms cash flows and reshapes the liquidity of financial portfolios, in part by transferring risk from sellers to buyers of the structured products. Structured finance mechanisms have also been used to help financial institutions remove specific assets from their balance sheets.

Examples of Structured Finance Products

When a standard loan is not enough to cover unique transactions dictated by a corporation's operational needs, a number of different structured finance products may be implemented. Along with CDOs and CBOs, instruments such as collateralized mortgage obligations (CMOs), credit default swaps (CDSs) and hybrid securities combining elements of debt and equity securities are often utilized.

Securitization is the process through which a financial instrument is created by combining financial assets, commonly resulting in such instruments as CDOs, asset-backed securities and credit-linked notes. Various tiers of these repackaged instruments are then sold off to investors. Securitization, much like structured finance, promotes liquidity and is also used to develop the structured financial products used by uniquely qualified businesses and other customers.

A mortgage-backed security (MBS) is a model example of securitization and its risk-transferring utility. Mortgages may be grouped into one large pool, leaving the issuer the opportunity to divide the pool into pieces that are based on the risk of default inherent to each mortgage. The smaller pieces may then be sold to investors.

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