What Are the Pros and Cons of Structured Finance?

Structured finance is a set of complex transactions offered for financing purposes. In some cases, a financial institution may use these instruments to help increase equity financing use by businesses. A few common types of structured finance options include collateralized bond or debt obligations along with other syndicated loan items. The pros to these finance options may be the ability to package both good and bad loans together and garner higher rewards for riskier investments. Cons include increased risk and the ability for the obligations to be worthless, especially during economic downturns.

Businesses often need different types of financing for the many needs of running an organization. Structured finance allows the company to create a debt or bond obligation from loans that investors can purchase as a financial investment. These financial securities are common in the mortgage industry, where the lender places multiple mortgages into one single securitized investment. Investors can benefit from these instruments because the good loans — that is, those that are most secure in the payments from borrowers — offset the riskier loans. Another pro for these financial instruments is the potential for higher returns.

Purchasing investments are all about the financial returns. One problem with individual investors is their inability to earn the best or highest financial returns without the use of copious amounts of capital. Collateralized bond or debt obligations can offer individual investors better opportunities for higher financial returns. In many cases, these structured finance options allow for groups of investors to purchase these instruments together. Each investor then has the option to make higher financial returns from the pooled funds in these securitized instruments.

One drawback to structured finance investments is the increased risk associated with the bond or debt obligation issued by a financial services company. For example, mortgage-backed options can be risky when the individual mortgages wind up in default. Financial services firms are then unable to pay investors any financial returns as no funds come in from the mortgage holders. These are actually two cons of structured finance wrapped into one large investment. The riskiest investments among these are often those collateralized instruments that have the riskiest loans in the total investment.

Investors must also be aware of the financial institution’s rating when purchasing structured finance options. For example, those institutions with lower ratings rend to have increased risk with their bonds. Investors may not desire these collateralized instruments as the risk is already at the forefront.