Structured finance
Principles of Finance glossary · Principles Of Finance
Definition
The use of special-purpose vehicles, tranching, and credit enhancement to transform pools of assets into tailored securities.
Structured finance in plain English
Structured finance is the art of taking a big pile of loans -- like thousands of mortgages or car loans -- and repackaging the cash they pay in into brand-new investments tailored to different buyers. The pile is placed into a separate legal box (a 'special-purpose vehicle') so it stands on its own, then chopped into layers called tranches, where the top layer gets paid first and safest while lower layers get paid last but earn more; 'credit enhancement' adds extra safety cushions to make the top layers especially secure. It's like sorting one giant fruit harvest into premium, standard, and bargain crates so each shopper gets the risk-and-price mix they want. This is powerful for spreading risk, but as the 2008 crisis showed, it goes badly wrong when the underlying loans are worse than everyone assumed.
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