To start out, Wikipedia does a serviceable job of getting us going, definition-wise:
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 securitization 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.Okay, let's start by looking at securitization: specifically, securitization of mortgages. That's a hot topic. We'll pay a visit to a site I found called Derivative Dribble, written by Charles Davi. He's the self-described resident derivatives wonk at the Atlantic Business Web site. He aims for lucidity when he writes -- kinda like me actually. Here's how he begins his explanation (the bold is mine):
We will explain how securitization works by first exploring the most basic motivation for isolating assets: access to cheaper financing. Assume B is a local bank that focuses primarily on taking deposits and earning money through very low risk investments of those deposits. Further, assume that B is a stable and solvent bank, but that it lacks the credit quality of some of the larger national banks and as such it has a higher cost of financing. This higher cost of financing means that it can’t lend at the same low rates as national banks. B’s local community is one in which home values are high and stable, and as a result the rate of default on mortgages is extremely low. As such, B would like to be able to compete in the local mortgage market, but is struggling to do so because its rates are higher than the national banks. What B would really like to do is borrow money for the limited purpose of issuing mortgages in its local community. That is, B wants to separate its credit quality from the credit quality of the mortgages it issues in its community. Securitization is the process that facilitates this isolation.So what do we have in Bank B? A stable, solvent bank that makes low-risk investments. Hmm. I know what you're thinking -- if only we had a few more of those around! So if you cleave to one view of finance -- that your friendly neighborhood bank should be making low-risk investments and not doing anything too dangerous -- then you're probably ready to give up on securitization already. But let's keep going.
Bank B wants to grab some market share in its community, where home prices are high and stable. (Ah, did you catch that? High and stable ... so we're postulating a community rather like Lake Wobegon, where all the women are strong, all the men are good-looking, all the kids are above average -- and all the home prices are high and stable. So you may wonder -- what happens when Bank B tries this same strategy, but home prices are low and volatile, or only appear high and stable but are actually poised for a crash?)
Moving on: "B wants to separate its credit quality from the credit quality of the mortgages it issues in its community." B wants to enjoy the same solid credit profile of a large national bank and save a few basis points on the cost of its funds. Sounds like a win-win, right? Consumer gets a cheaper loan, B gets access to cheaper financing, so what's not to like?
Well, why does B have lower credit quality and access only to more expensive financing? Sure, it could be simply due to B's smaller size. But what if it isn't, not completely? What if one reason B's credit quality lags is that, even though it appears to be a stable institution, its loan agents aren't the sharpest saws in the shed. Not by much -- I mean not enough to get it into trouble really -- but should it really be allowed to simply pass its credit risk, even if small, down the chain?
Or here's another thought: Let's even say Bank B is perfectly responsible, but once it gets into this securitization business all of a sudden something happens. Its incentive structure changes. It's skimming a fee off these loans and not holding them anymore, so who's to worry about the borrower defaulting? All of a sudden Bank B basically starts flinging beef into the securitization machine to be turned into tranche patties of mortgage securities.
Now here's the next step Davi outlines:
We know that so long as B owns the mortgages, B’s creditors will still consider B’s credit as an institution when lending to it, even if that lending is for the limited purpose of issuing local mortgages. The solution to that problem is simple: B sells the mortgages off shortly after issuing them. But to whom? Well, common sense tells us that investors are not going to be too excited about buying mortgages piecemeal. So, B will wait until it has issued a pool of mortgages large enough to attract the attention of investors. Then, it will set up a special purpose vehicle (SPV) where that SPV’s special purpose is to buy the mortgages from B.So B is out of the picture now. Phew. Or is it? Look over news stories from the past two years and count up all the banks that tractor beam-ed in their structured investment vehicles after these entities began to flounder financially. And who invented the SIV back in 1988? A bank that right now isn't exactly a shining beacon of financial stability and good sense: Citigroup.
Time to skip right to his conclusion:
Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage.Now let's think hard about this. These mortgages are being sold on to investors. All the securities will have to be rated by a big-name rating agency, say S&P. Now how many S&P analysts do you think live in our imaginary Lake Wobegon? No, they're in their New York City bunker. They're not going to know anything about the local steel mill rumored to be in danger of closing, about the series in the newspaper suggesting a toxic underground plume of chemicals may be spreading near the neighborhood of homes whose mortgages they're rating, about the fact half these places are in a neighborhood starting to go to seed. Instead they'll just look at the area's default rates, sales prices, then crunch numbers in some model.
Of course the best people to judge what's going to happen to these mortgages probably sit right in the headquarters of Bank B. They're doing banking for the community's needs. The bankers drive through these neighborhoods all the time. They see fresh construction projects on the east side, they see acts of vandalism on the north side, they know which business are doing well, and where, and have some sense of the community's future.
Okay, that went much longer than I expected! Enough for today. But I've got many more thoughts (and much more material) for future installments of this look at structured finance.