- Christian Armbruester
Investment Risk Guide - Part 3: Structured Credit
The term “structured” in of itself implies complexity, and there is nothing simple about coming to terms on lending arrangements involving very specific forms of collateral. Unlike a government or a corporation, the risk with lending on single assets or projects is very concentrated. What makes matters even worse is that there are no economies of scale in doing bespoke things. It takes time and expertise to assess the individual risks one is taking on in a structured lending strategy and the question is, how much is the collateral worth if it were to come to a default? Commensurately, the costs and fees are much higher for these types of investment strategies, but so are the expected returns.
The most common form of structured lending is bridge financing, whereby a borrower needs money to close on a transaction. To entice a lender to make a quick decision, the borrower can then pledge an asset which offers (more than) enough security. Say you have an asset worth £2m (at market prices), yet offered to secure a loan worth £1m, that eliminates a huge amount of the risk for the lender. Often, bridge loans are very short in duration, as the cost to the borrower is very high. But for so long as the borrower has more to gain, from short term pain, bridge financing is a classic win-win, and explains the popularity of this investment strategy.
Another form of structured credit is project loans. Here, for example, an infrastructure development, such as a solar plant, tunnel or pipeline is financed via private syndications. Usually, the terms are very long in duration, which accounts for much of the return these loans pay out (illiquidity premium). Project lending is usually fairly low risk, as the sheer scale of these undertakings tend to involve large corporations and government support, which decreases the probability of default.
Then there are the things that gave the last crisis its bad name: Collateralised Debt Obligations (CDOs). Basically, a number of different credit instruments (such as mortgages, bonds or loans) are pooled together to create a single debt instrument. Oftentimes, the CDO is then split into different tranches, in terms of which is superior over another in the event of a default. This allows a very fine segmentation of risk and creates a very opaque world with very many bespoke agreements and contracts from which to value parts of a derivative, whose intrinsic value is not only subject to market risks and corporate credit risk, but also the legal framework to which it is tied as part of the CDO. Good luck with that.
See our next post on Beta > in this six-part series, as we look into all the core risk categories.