It can be argued that structured finance creates greater efficiency in our financial system because capital is freed up to pursue other goals. Although it can also be argued, as Warren Buffet did, that derivatives, products of structured finance, are “financial weapons of mass destruction”. Both arguments stem from the same characteristic of these securities: excessive leverage.
When the loan that became part of the secured debt was issued, that money was created out of thin air by the original lender. This is how all money is created in a fractional-reserve banking system. As long as there is sufficient cash, the creation of debt is normal; however, when excessive debt is created and free cash flow cannot service that debt, the system experiences the very serious problem of insolvency which can lead to currency deflation, the disappearance of money created by the lender in the ether from which it was created.
If an individual investor wanted to purchase a mortgage, the purchase would be made with equity rather than money created by the lender. However, once packaged into a Collateralized Debt Obligation (CDO), the senior tranche is often purchased by an investment banker or other lender who also created that money out of thin air. Since the equity tranche does not raise any capital, the mezzanine tranche may be the only money in the structure that was not created by an out-of-ether lender. With so little “real” money in the transaction, there is very little buffer between what would be a loss of invested capital and a bank loss of created capital. There is a tipping point where debt service exceeds cash flow, and when that tipping point is reached, the whole debt structure can collapse into a deflationary spiral.
Structured finance products such as secured debt securities and their derivatives are highly leveraged instruments with a very sensitive tipping point. These instruments are also very sensitive to the availability of short-term credit and lending rates. Long-term CDOs were often funded by continually rolling over short-term debt. The rising cost of short-term debt would take some time to cause trouble, but a sudden withdrawal of credit availability, as seen during the credit crunch, meant desperate sales for those who owned these implements. Currency deflation was a major concern for the Federal Reserve as the Great Housing Bubble began to deflate.
The use of structured finance techniques in the syndication of collateral debt was not in itself a problem that caused the Great Housing Bubble. This was part of the infrastructure for providing capital to the mortgage market that began with the creation of the secondary mortgage market. In the aftermath of the housing price crash, secured debt securities received a bad rap as dangerous securities unworthy of the vault, from the “AAA” ratings they received from companies that assess creditworthiness financial instruments.
The benefits of structured finance have not disappeared because of market problems or the misguided ratings these securities have received. Asset-backed bonds as syndicates of mortgage-backed securities almost disappeared in 2008. However, they have not disappeared and will continue to be an integral part of the capital delivery system providing money to buyers to buy residential real estate.