This is the fifth article in my series on commercial second mortgages, and it will be the hardest article in the series to understand. Just try to get through it.
Rest assured that I am leading you to a warm, profitable place; but first you have to understand commercial second mortgages (done), mezzanine loans (done), structured finance (today's subject), preferred equity, and finally equity. I promise that you will be well-rewarded for following along.
What is structured finance? According to Wikipedia, structured finance is a broad term used to describe a sector of finance that was created to help transfer risk and avoid laws using complex legal and corporate entities. In commercial real estate finance, the risk to be avoided is any default risk, and the law to be avoided is any income taxes. Are your eyes glossing over? Perhaps an example will help.
Wall Street investment bankers are considered to be using structured finance when they securitize credit card debt, scratch-and-dent home loans, auto loans, and sub-prime commercial mortgages into mixed pools. These pools are a real hodge-podge of assets. The loans in this giant pool are held by a pass-through trust (a special kind of trust that doesn't have to pay income taxes).
The trust then issues bonds backed by the loans in the pool. These bonds are called asset-backed securities (ABS) or collateralized debt obligations (CDO's). Please don't give up on me. All we are doing is making soup. We have a great, big pool of water, and we are sprinkling in some car loans, some credit card loans, and some poorer-quality home loans and commercial loans. We are calling the soup a C.D.O., and the bonds that will be issued by the pool are simply called asset-backed securities.
Different classes of bonds would have different levels of risk, called tranches. The entire CDO would be rated by some rating agency, and each tranche would be assigned its own risk-rating and yield. Investors could then choose the tranche that they wanted to invest in, according to how much risk they were willing to accept. The more risk they accepted, the higher the yield they could earn.
By breaking a debt offering into tranches and giving investors the chance to choose their risk level, investment bankers discovered that they could get far more money for the pool of loans. A single buyer of the entire pool of loans might only pay $250 million; but if the bonds were broken up into tranches and rated, the investment bankers might get a whopping $290 million for the same pool of loans. (CDO pools are typically much smaller than CMBS pools.)
"Gee, George, these fancy structured finance securitizations you described above sound just like garden-variety mortgage-backed securities." Fannie Mae and Freddie Mac have been securitizing residential mortgages for forty years. Conduits have been securitizing commercial mortgage-backed securities (CMBS) for over a decade. Tell me something I didn't know."
Asset-backed securities (ABS) are very similar to mortgage-backed securities, except that some of the loans in the pool are not mortgages. Remember, we have lots of auto loans and credit card loans in the pool.
Hey, we're almost done for the day, and the following is possibly the most important point:
When investment bankers, commercial bankers, and mortgage originators use the term, structured finance, in the context of commercial real estate finance, they usually just mean the making of mezzanine loans, preferred equity investments, and equity investments.
"Geez, George, couldn't you have just said that in the first place? My brain feels like its gonna explode!" :-)
