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Structured asset finance is the pooling of investments to distribute risk and minimize expenses to clients. As the name implies, it involves an element of “structuring” by changing the nature of assets in some way to secure them and provide other benefits. Numerous financial institutions offer this service and trade heavily in structured assets. This aspect of the financial industry tends to experience regulatory lag, which can create problems when financial companies fail to behave responsibly and regulatory authorities cannot keep up.
One aspect of structured asset finance is securitization to reduce the risks associated with leases, loans, and other activities by securing the underlying asset. Financial companies can use a variety of tools for securitization; in a simple example, an asset itself can be a security, as seen with many car loans. Firms can also create new financial products such as mortgage-backed securities. Such activities can allow firms to extend more and larger loans as part of their practices, and they can also trade their loans as financial products, rather than retaining them in portfolios.
Another activity is tranching, which allows firms to rank investments within a pool. Tranching can be a key component of structured asset finance, as it allows for the creation of pools of securities that do not necessarily pay out equally. Investors can buy into different components to receive more or less security. Tranching can allow for further risk distribution as well as the development of more financial products than might otherwise be available.
Large companies rely on structured asset finance for the purchase of big ticket items like commercial aircraft, mining equipment, and boats. Most companies do not have the cash to buy such assets outright, or do not want to tie up available cash in an asset. Instead, they turn to financial institutions for financing options. A single institution wouldn't want to bear the risk of the purchase, so it uses structured asset financing to make financing available to its institutional and corporate customers.
Structured asset finance can also be applied to consumer finance. Consumers who might not qualify for loans or might receive poor terms can participate in structured asset financing to get access to credit. Their loans are pooled with those of borrowers who have high credit ratings, creating a mixed pool of investments a bank can repackage and sell. Buyers of such pools, or shares in them, take a chance on the risk on the grounds that the bulk of the investments may have a good rating, and thus default on a small percentage of loans won't utterly devalue the investment.