Structured Securities

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 other owners according to a set of prespecified rules. 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, alhtough 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 consider to bundle some of its loans together to sell as a structured security.

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 oppurtunities that the bank could pursue if it had funds.
• The bank may wish to alter is 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.

Steps to Creating a Structured Security

• Porfolio Selection : When a bank structures a security, it usually has a target for the credit rating that it wishes the security to have. In fact, it will work with the credit rating agencies to achieve the desired rating. The primary way to achieve a target credit rating is by altering the mix and credit worthiness of the assets placed in the structure.
• Security Structure In addition to choosing the assets to back a given security, the issuer must determine the security structure. That is, the cash flows generated by the underlying pool of assets are routed to different investing groups, called tranches, through a pre-defined algorithm. For instance, one structure could route all princial payments to one tranche first, and then principal is paid to a second tranche after the first tranche has been paid off.
  
  In this way, each tranche of a structured security can have different credit profiles, as well as maturities and other characteristics. The tranches can be structured in any way.
• Credit Enhancement If the estimated credit rating of a given structure is not as high as the issuer desires, they can add a credit enhancement to the structure. A credit enhancement is some sort of guarantee to cover a certain amount of losses in the structure. This can be a guarantee from the issuer of the security, or from some other third party who is paid for the guarantee. Additionally, the issuer can overcollaterize the security, in which case, excess cash flows revert back to the issuer.

Forecasting Cash Flows

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.