2. Read and summarize chapter 26 of your Financial Management text book in at least 400 words.
-Explain the concept of “reducing funding costs.”
– How important is credit when trying to obtain financing?
– Please complete questions #9,#10 and #12 of the chapter.
An alternative to the issuance of a corporate bond, a corporation
can issue a security backed by loans or receivables. Securities that
have as their collateral loans or receivables are referred to as asset-
backed securities. The transaction in which asset-backed securities are
created is referred to as a structured finance transaction or structured
financing. In this chapter, we will explain what is meant by a structured
finance transaction, the reasons why a corporation would use a struc-
tured finance transaction rather than issue a corporate bond, and how
rating agencies assess the credit risk of a structured finance transaction.
While our focus in this chapter is on structured financing used by corpo-
rations, it should be noted that some municipal governments use this
form of financing rather than issuing municipal bonds and several Euro-
pean central governments use this form for financing.
WHAT IS A STRUCTURED FINANCE TRANSACTION?
The term “structured finance” refers to a wide variety of debt and
related securities. The key element of structured financing is that the
obligation of the issuer to repay lenders is backed by the value of a
financial asset or credit support provided by a third party to the transac-
tion.1 When we say the value of a “financial asset” we mean a loan, an
account receivable, or a note receivable. Keep in mind that a loan or a
1 Andrew A. Silver, “Rating Structured Securities,” Chapter 5 in Issuer Perspectives
on Securitization (New Hope, PA: Frank J. Fabozzi Associates, 1998), p. 5
A
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862 SELECTED TOPICS IN FINANCIAL MANAGEMENT
receivable is a financial asset to the lender but a liability to the bor-
rower. So, in a structured financing, the lender is using a pool of loans
or receivables as collateral for debt instruments that it issues. To obtain
a desired credit rating sought by a corporation for the asset-backed
securities created by using a structured financing, both the value of the
financial assets and a third-party credit support may be needed.
In Chapter 15 where we discuss intermediate- and long-term debt
instruments, we described secured debt instruments whose credit stand-
ing is supported by a lien on specific assets (i.e., a mortgage bond or col-
lateral trust bond) or by a third-party guarantee. However, with
traditional secured bonds, it is the ability of the issuer to generate suffi-
cient earnings to repay the debt obligation that is necessary for the issuer
to repay the debt. So, for example, if a manufacturer of farm equipment
issues a mortgage bond in which the bondholders have a first mortgage
lien on one of its plants, the ability of the manufacturer to generate cash
flow from all of its operations is required to pay off the bondholders.
9. Why should the investor in an asset-backed security be concerned
with the capability of the servicer
10. What are the obligations that must be paid by the issuer of an asset-
backed security?
12. Why doesn’t an issuer of an asset-backed security seek the highest
credit rating of triple A?
