Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Structuring====== 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. ===== How Structuring Works: The Chef's Kitchen ===== 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. ==== Step 1: Pooling the Assets (Gathering Ingredients) ==== 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: * Mortgages on residential homes * Car loans * Student loans * Credit card debt * Corporate bonds 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. ==== Step 2: Slicing and Dicing (Creating Tranches) ==== This is where the real magic—and potential danger—happens. The pooled assets are carved up into different slices called [[tranche]]s (from the French word for 'slice'). Each tranche has a different level of seniority, which determines the order in which it gets paid. * **The Senior Tranche:** This is the safest slice. It gets paid first from the cash flows of the underlying assets. Because of its lower risk, it offers the lowest return (interest rate). It's designed for conservative investors like pension funds. * **The Mezzanine Tranche:** This is the middle slice. It only gets paid after the senior tranche is fully paid. It carries more risk but offers a higher return to compensate. * **The Equity Tranche (or Junior Tranche):** This is the riskiest slice. It's the last to get paid and the first to absorb any losses if borrowers in the original pool start defaulting on their loans. To attract thrill-seeking investors, it offers the highest potential return. ==== Step 3: Selling the New Product (Serving the Dish) ==== 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. ===== The Value Investor's Perspective ===== 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. ==== Complexity is the Enemy ==== 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. ==== Misaligned Incentives and Agency Problems ==== 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. ===== A Final Word: Friend or Foe? ===== 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.