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What is Structured Finance?

Structured finance is an innovation of the finance industry on Wall Street. It is a method of redistributing risk based on complex legal and corporate entities such as corporations, limited liability companies or some other kind of legal entity capable of entering into contracts. The shares or other interests in structured financial entities are derivatives that obtain their value from an underlying asset.

Any asset that has a regular cashflow can be pooled through structured finance to create an asset-backed security. This cashflow can be split among various parties and valued based on the risk of repayment. For instance, the most common form of structured finance utilized to inflate the Great Housing Bubble was the collateralized debt obligation or CDO.

A CDO derives its value from the underlying, asset-backed securities which in the Great Housing Bubble were generally bundles of mortgage loans. Mortgage loans generate a steady cashflow stream as individual homeowners pay their mortgage obligations, and these loans are collateralized by residential real estate. In the event of default on the mortgage held by a CDO, a house can be put through foreclosure to satisfy the mortgage debt and thereby return capital to the CDO.

In any asset-backed security, assets are bundled together to reduce risk and make the asset more attractive to investors. In contrast, if an individual buys a mortgage loan from a lender in order to receive the interest payments, this investor assumes all the risk of default. The default loss risk might be low, but if one party must bear this risk, the investor significantly discounts the security to compensate. However, if this individual investor buys a small share of a large pool of mortgage loans, the investor reduces risk exposure significantly and thereby the discount for purchasing it. The value of the security is increased by pooling and thereby lowering the risk. Also, for an individual investor to purchase a mortgage loan requires a significant equity investment as mortgage loans are often in the hundreds of thousands of dollars. If a number of mortgage loans are pooled and sold off to many investors as shares or interests in a financial intermediary like a CDO, the equity requirement can be lowered considerably thus opening this type of investment to a broader investment community. It is the spreading of risk and the lowering of equity thresholds that makes structured finance such an appealing investment tool.

Innovations in structured finance provided the capital delivery mechanism that helped inflate the Great Housing Bubble. Structured finance is merely a tool. If used appropriately, it can speed the delivery of capital and create a more efficient capital market. If used inappropriately, it can be a financial weapon of mass destruction, and it can threaten our entire capitalist system.

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