Overview
A structured security is a security that is constructed by bundling together a bunch of other securities, and then routing the cash flows from this bundle to a set of owners. The exact amount of cash paid to each owner is specified by a set of rules set at the time issuance.
The simplest structured instruments are simple pass through instruments, that is, the cash flows from the underlying are just passed along to the holders of the structured instrument, although much more complicated instruments are common as well.
Reasons for Creating a Structured Security
Banks are the primary providers of structured securities. Through the normal banking operations, they issue loans of various types, including mortgages, construction loans, auto loans, credit cards, etc... A bank may decide to sell these assets to the market, thereby raising cash.
From an efficient market perspective, this activity does not create value for the bank. Assuming that the bank is selling the security at a fair market value, they are just exchanging one market priced asset for another. In fact, there is probably a loss of value due to transaction costs. However, this process can provide some benefits for the bank.
- The bank may need to raise liquidity. This could be because the bank is running low on liquidity, or there are other opportunities that the bank could pursue if it had funds.
- The bank may wish to alter its risk profile. Selling a pool of assets and then using the funds to invest in a different type of asset will shift the banks risk profile.
- The bank may wish to recognize gains in its accounting statements. That is, the market price of the assets it is placing in the security may have moved up since the time of issuance. This increase in value may not be recognized in the financial statements of the firm. Selling them allows the bank to book those gains.
Topics
- Structured Security Types
- Steps to Creating a Structured Security
- Legal and Operational Issues
- Trading
- Valuation
- Forecasting Cash Flows - the process of forecasting the cash flows from the pool of assets, as well as how those cash flows get routed to the liabilities of the structure. This process is central to understanding the credit risk assigned to the security.