What is structured property finance

Structured property finance is a portion of the finance industry, it deals with the management of leverage and risk. The strategies involved are centred around legal and corporate restructuring, which involves off balance sheet accounting and the use of financial instruments.

Structured property finance generally falls under three main headers, Securitisation, Tranching and Credit Enhancement.

Securitisation

Securitisation is the practice of grouping together different types of contractual debt, for example various types of mortgages, car finance or credit card debt, and selling the cash flow onto a third party who takes these on as securities.

Tranching

Tranching is the creation of different classes of securities from the same pool of assets. It is the system used to create different investment classes for the securities. Tranching allows the cash flow from the underlying assets to be diverted to various investor groups. Tranching is explained on Wikipedia as follows, “A key goal of the tranching process is to create at least one class of securities whose rating is higher than the average rating of the underlying collateral pool or to create rated securities from a pool of unrated assets. This is accomplished by the use of credit enhancement, such as the prioritisation of payments to the different tranches.”

Credit Enhancement

Credit enhancement is essential in creating securities with a higher rating than any underlying asset pool. The issuing of subordinate bonds is an example of the use of credit enhancement to allocate any losses from the collateral before losses are allocated to the senior bonds, this then boosts the credit of the senior bonds, i.e. credit enhancement.

The ratings of the securities play an important part in structured property finance for instruments that are meant to be sold to investors. Many mutual funds, governments, and private investors will only purchase instruments that have been rated by a known credit rating agency.

Types of financial instruments

There are a few main types of financial instruments used in structured property finance, there are securities, obligations and derivatives amongst others.

Securities

Securities fall under two main headers, asset-backed securities and mortgage backed securities. Asset-backed securities are bonds or notes which are based upon pools of assets and their respective cash flow from a specific pool of underlying assets. Mortgage backed securities are asset-backed securities, but they rely on the principal payments and interest from a group of mortgage loans to generate cash flow. There are a few types of mortgage-backed securities, residential, commercial and collateralized. Residential mortgage-backed securities are typically residential homes with single family occupancy. Commercial mortgage-backed securities are based on commercial entities such as shopping centres or office blocks. Insurance linked securities are used to transfer risk linked to insurance losses in the case of a catastrophic event, which are usually seen as uncorrelated to traditional finance markets.

Obligations

Collateralized mortgage obligations are typically grouped mortgage-backed securities with varying levels of seniority. Collateralized debt obligations are comprised of fixed income assets, these include high yield debt, asset-backed securities, which is pooled together and then divided into various tranches. Collateralized debt obligations are made up of three types of obligation, collateralized bond obligations, comprised of corporate bonds, collateralized loan obligations, comprised of bank loans, and commercial real estate collateralized debt obligations, comprised of commercial real estate loans and bonds. Collateralized fund obligations are backed primarily by the securitisation of private equity and hedge fund assets

Derivatives

Credit derivatives are contracts that are made to transfer the risk of the total return of a credit asset falling below an agreed level, without the transfer of the underlying asset.

Off Balance Sheet Accounting

Off balance sheet accounting, also known as Incognito Leverage, is an item such as an asset, debt or financing activity not included on a company’s balance sheet. Typically, banks lend to consumers under tight criteria, keeping these loans on their balance sheet and retaining credit risk. In the contrary, securitisation enables the banks to remove loans from balance sheets and transfer the risk associated with those loans.

Off balance sheet accounting was accountable for the Enron scandal and is now governed by a strict set of financial rules to prevent these events from happening again. In the case of Enron, they would build an asset, such as a power station, and claim the projected profit as if it was on the books. This was even though they hadn’t made any profit from the asset. When the profit made wasn’t anywhere near the amount projected, they would transfer the assets to an off the books corporation, where any losses would go unreported.

In summary, structured property finance is a way of offsetting the leverage contained in an asset, for example anything from a residential home to a commercial structure like a block of offices or even a power station, and placing that value into securities which can be grouped together into tranches with varying values. This allows the cash flow from these investments to be diverted to various investor groups. To maximise the value of the securities, the issuing of subordinate bonds can boost the senior bonds credit value and place any losses in a subordinate bond rather than in the senior bonds. The securities then have a rating applied, according to their respective value, and can be traded on the stock exchange to be bought by mutual funds, governments or private investors. This form of finance has been misused in the past, but it is now governed by a strict set of rules which should prevent another catastrophic failure of the stock markets if the market value of companies is misrepresented by the use of off balance sheet accounting methods, but loopholes will still allow companies the chance to have more assets and fewer liabilities on their balance sheets.