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What is Structured Finance ?

If the current crisis (labelled as the subprime crisis) has highlighted the complexity of structured finance along with the necessity of developing more sophisticated risk management tools, it appears that a great deal of misunderstanding still prevails among economic and financial decision makers.

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It is therefore interesting to analyse the concept of structured finance and the concepts surrounding it. In this respect, structured finance can be defined through three features. The first of those consists in selecting financial assets through a process called pooling which leads to the creation of a portfolio. The assets themselves are usually credit instruments. Then, the cash flows linked to these assets are structured in different tranches the latter possessing varying risk characteristics. The structuring is tailored in such a way that the tranches are suited to different types of investors. Finally, the portfolio is integrated within a structure called Special Purpose Vehicle (SPV) which is isolated from the default risk of the original issuer.

Issuing tailored financial assets

There is a double incentive behind structured finance operations. As far as banks are concerned, the original issuer (called the originator) removes the credit risk from its balance sheet thus reducing its capital exposure. This falls in line with Basel II regulations. Regarding investors, the latter can achieve portfolio diversification while at the same time investing in assets with an attractive risk / reward profile. Economists have described this process as market completion since special assets which are not readily available on the market are being created. How are these tranches structured?

First of all, the returns on the tranches depend on the default risk attached to the credit portfolio. However, the tranches bear differing exposures to the default risk. Simply put, they can be divided into three categories. The equity / first loss tranche is meant to absorb the first losses that impact the portfolio. Then, when the losses are bigger than what can be absorbed by the first tranche, the mezzanine tranches come into play. Finally, the “monetary” tranches are supposed to be isolated against any risk except when it comes to exceptional circumstances. These exceptional circumstances are now known….

The intervention of several participants complicates the analysis

Who are the different participants intervening in the structuring process? An “unarranger” comes first and conceptualizes the structure by defining the tranches and finding the investors. The original institution provides the financial assets. The “servicer” collects the payments due and audits the portfolio performance. The “trustee” is in charge of ensuring that compliance procedures are applied with regard to the structure’s specific characteristics. In order to upgrade the rating of some tranches, financial guarantors bring guarantees to some tranches. Finally, investors purchase the various tranches depending on their appetite for risk. This rating process is important since the rating agencies provide an evaluation to each tranche by taking into account the risk attached to them as well as information regarding relevant third parties.

It must be noted that the structuring and organization of the different tranches complicates risk analysis as well as following the various responsibilities of the different parties involved. It is necessary that the documentation clearly defines the responsibility of each party within every possible scenario. The aim is to assess the impact of a default of one the counterparties present in the structure. Conflicts of interest and links between the various parties must be assessed as well. Simply estimating potential loss distribution in a portfolio is not enough.

Beware of the impact of unexpected defaults

The impact of loss distribution differs from that of a standard risk portfolio. The tranches have a varying sensitivity when unexpected defaults occur. Let us consider the “monetary” tranche which is relatively isolated against default risk since it only absorbs extreme risks. If loss distribution resulting from defaults is not properly estimated, risk exposure will be greater since this tranche only has a small probability of being hit by the losses. Extreme risks remain however quite difficult to evaluate considering their nature. This is compounded by the fact that risk correlations which are hard to assess have to be taken into account.

As was mentioned previously, the tranches are assessed by the rating agencies. Some precisions are necessary regarding this. The rating is usually carried out on the basis of expected loss and default probability. Loss distribution can however be more or less extreme depending on the default probability and expected loss. It is therefore necessary to take into account what can be defined as unexpected losses in financial jargon. Vigilance is necessary when structured product tranche ratings are being used. The current crisis validates this.

Some argue that the use of such products will be limited in the future. Thus is unlikely to happen due to their economic role in terms of market completion. However, the development of more elaborate risk management methods will be necessary. This will allow the setting up of a more appropriate “due diligence” that shall increase the confidence with which these products can be used.

Michel Verlaine , October 2007

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