Structuring (sometimes called financial engineering) is the art and science of creating a new financial instrument by bundling together a variety of underlying assets. Think of an investment bank as a master chef. The chef doesn't just serve you a raw carrot or a plain chicken breast; they combine various ingredients—meats, vegetables, spices—to create a complex, layered dish. Similarly, a financial “structurer” takes a pool of assets, such as mortgages, car loans, or corporate debt, and slices, dices, and repackages them into a brand-new security with its own unique risk and return characteristics. This new creation, known as a structured product, is then sold to investors. The most infamous examples are the Collateralized Debt Obligation (CDO)s and Mortgage-Backed Security (MBS)s, which were central to the 2008 financial crisis. Their complexity hid enormous risks, proving that what's inside the package is far more important than the fancy wrapper.
At its core, structuring is a process designed to transform the risk and cash flow profiles of assets to appeal to different types of investors. While the details can become mind-numbingly complex, the basic recipe is quite straightforward.
The process begins with an institution, typically a large bank, gathering a large, diversified pool of cash-flow-generating assets. These can be almost anything that involves regular payments:
This collection of assets forms the foundation of the new security. The idea is that a large, diverse pool is more predictable than any single loan within it.
This is where the real magic—and potential danger—happens. The pooled assets are carved up into different slices called tranches (from the French word for 'slice'). Each tranche has a different level of seniority, which determines the order in which it gets paid.
Once sliced, these tranches are packaged as a new security and sold to investors whose risk appetites match the profile of each slice. The bank that created the product earns hefty fees for its work.
For value investors, structuring often raises more red flags than it does opportunities. The philosophy, heavily influenced by figures like Warren Buffett, prioritizes simplicity, transparency, and a deep understanding of what you own. Structured products frequently violate all three of these principles.
Buffett famously advises, “Never invest in a business you cannot understand.” Structured products are often deliberately complex. This complexity can obscure the true quality of the underlying assets. When you buy a simple stock, you can analyze the company's business. When you buy a CDO, you are buying a piece of a thousand different loans, all with different characteristics. It is nearly impossible for an ordinary investor—and often even for professionals—to perform adequate due diligence.
The creators of structured products (the “sell-side” banks) make their money from fees generated by creating and selling them. Their incentive is to produce more products, not necessarily better ones. This creates a classic agency problem: the bank's interest (earning fees) is not aligned with the investor's interest (making a sound long-term investment). During the lead-up to the Great Financial Crisis, this led to banks packaging increasingly risky, low-quality “subprime” mortgages into securities that were given misleadingly high credit ratings.
Structuring is not inherently evil. In theory, it is a valuable tool for financial markets, allowing risk to be efficiently distributed to those best able to bear it. However, in practice, it often creates opaque, complicated instruments that benefit the sellers far more than the buyers. For the ordinary investor, the lesson is simple: if you can't explain what you own to a teenager in three minutes, you probably shouldn't own it. Instead of being tempted by the promise of a fancy, structured dish, a value investor is usually better off sticking to simple, understandable ingredients whose quality they can judge for themselves.