Structured Finance 101: What It Is and How You Break In
I’ve gotten requests to cover dozens of different topics – some of which are easy to find information on, and others that require Jack Bauer-style interrogation techniques to find clues.
In the latter category is Structured Finance – look around online and you’ll find dozens of different definitions and contradictory descriptions of what it is and what you do there.
The same thing happened when I started poking around online as well, so I decided the next best alternative would be finding a willing interviewee who works in the field – and that’s why you’re reading this right now.
Here’s what you’ll learn in Part 1 of this crash-course on Structured Finance:
- How our interviewee moved from a liberal arts background with no finance experience to a bulge bracket bank.
- What you do in Structured Finance.
- How it’s different from investment banking, ECM, DCM, LevFin, and sales & trading.
- How you break in and what to expect in interviews.
Background and Definitions
Q: Let’s start with your background. What’s your story, and how did you break into finance?
A: I went to a top 20 undergrad university, and was originally a pre-law major – but then I took a class on economic forecasting, got started building models, and became much more interested in finance since it was more exciting and in-tune with my personality.
I graduated into a recession where jobs were almost non-existent, so I had to cast a wide net to find my first full-time job. I started out at an investment consulting firm, where I mainly conducted due diligence on private equity firms and hedge funds. As a result of this experience, I became very interested in the buy-side.
However, I knew I would need a different skill set in order to break in. After some research I decided that a job in banking would give me the broadest and most applicable experience.
The only problem: I had a liberal arts background and little finance experience on my resume. So I decided to fix those problems by going through 2 levels of the CFA and then refining my financial modeling skills.
Q: Now I’m going to stop the interview and end this discussion because you just mentioned “CFA.”
Just kidding, since it was actually useful in your case.
A: I knew you were going to have that reaction! While it was essential for me to learn about finance and demonstrate that I was both serious and capable, now that I’m working at a bulge bracket bank I can attest to the fact that the CFA is (1) Not helpful for advancement, (2) Not valued by your bosses, and (3) Not possible to pass with the hours you’ll be working.
Q: And then? This story doesn’t end with the exam magically getting you in, right?
A: Nope. I went through tons of cold calls, resume submissions, and the usual networking tactics you’ve recommended before, and finally landed an opportunity at a regional boutique bank that focused on technology M&A.
We worked mostly with $10 – $100 million revenue companies, and I liked it quite a bit at first since it was small and since I worked directly with the Partners. I spoke with CEOs and CFOs and learned all about banking there.
But I missed being involved with the markets, which are not really part of the equation for small, privately-owned companies, so I jumped at the opportunity to work in the Structured Finance group of a bulge bracket bank once I had been at the boutique for a while.
By then, the markets and hiring situation had improved quite a bit – and I wanted to work with bigger companies and on bigger deals.
I hesitated only because I didn’t know exactly what Structured Finance was at the time.
Q: On that note, what exactly is Structured Finance? And how is it different from investment banking and sales & trading?
A: It’s harder to define because SF groups differ depending on the bank, and so you can’t apply a cookie-cutter definition as you could to, say, industry vs. product groups.
Basically, “Structured Finance” refers to Fixed Income products and mostly mortgage-backed securities (MBS) and asset-backed securities (ABS).
An asset-backed security is just a security whose value and payments are derived from and backed by a pool of underlying assets – auto loans, home equity loans, student loans, and credit card receivables, for example.
A mortgage-backed security is a subset of ABS where the security represents a claim on the cash flows from underlying mortgage loans.
“Structured” means that these securities are secured – backed by collateral – and so they’re different from unsecured bonds (i.e. high-yield debt).
In Structured Finance, we help companies raise capital by creating (“structuring”) these types of securities and then selling them to investors.
Q: OK, so it sounds like a Capital Markets group but it’s different from ECM since you’re not dealing with equity at all.
But how is it different from DCM? Aren’t you also working with secured debt there?
A: The difference is that DCM deals with “plain vanilla” debt – standard loans that companies issue and which are based on those companies’ financial profiles and credit ratings.
In Structured Finance, we can use tools like “credit enhancement” and “bankruptcy remoteness” in order to bridge the gap between a company’s corporate rating and an A and sometimes even an AAA rating.
Since the note has these buffers, investors are more comfortable buying the paper and therefore require a lower interest rate – which reduces the issuer’s cost of debt.
Q: So you’re making securities from risky companies look less risky by packaging them together in fancy ways.
What exactly are “credit enhancements?” What about a “bankruptcy remoteness?”
A: Well, they look less risky because they are less risky. There are a few types of credit enhancement (stay with me – we’re about to get technical):
(1) Overcollateralization – This is when the value of the collateral pledged is higher than the contemplated size of the bond. If you have a pool of auto loans worth $100 and you are asking investors for a $90 bond, this is an example of overcollateralization. The benefit is the extra collateral available.
(2) Subordination – Structured Notes typically have multiple classes of bonds. Let’s say we have a bond with three classes (A, B, and C) and that the bond pays sequentially and is secured by equipment loans (think tractors and bull dozers).
Bond A will pay down, while Classes B and C will earn interest. Once Class A is paid down completely, B will start, then C. If any losses occur they will be absorbed by Class C, then B. A enjoys credit enhancement through subordination of Classes B and C.
These are 2 examples of “credit enhancements” – making a security less risky by adding in special terms and pledges.
“Bankruptcy remoteness” means that if the issuing company ever goes bankrupt, the bankruptcy court cannot touch the collateral that secures the structured notes and cannot use them to pay off another party.
So it’s sort of like a get-out-of-jail-free card – even if the worst happens and the company collapses, investors still have protection.
And it’s a win for the company as well, because the security gets a higher rating and the overall cost of borrowing goes down.
Q: So it sounds like you’re mostly working with lower-credit-rating companies and businesses that are on the brink of bankruptcy?
A: We work with companies across the credit spectrum, but not usually with those on the brink of bankruptcy.
We generally work with auto loan, credit card, and student loan companies – secured loans are well-aligned with their business models since they have stable cash flows.
Those are 3 of the most common types of companies we work with, but you can securitize cash flows for almost anything with a fixed cash stream – things like alarm systems, or even movie studios’ film franchise revenues (Miramax just priced a deal recently).
It all comes down to the stability of the cash flows and how appealing we can make it look by packaging the securities differently.
Q: I see – we’ll get into the technical details of your work later, but thanks for pointing that out.
A: Sometimes we’re literally in competition with the DCM group – especially when the markets are poor and everyone’s fighting for the same funding. Both of us may go in and pitch the same companies on why they should pursue a certain financing strategy, so it can make for an awkward relationship.
There isn’t as much competition with Leveraged Finance since we often work with the LevFin team – companies sometimes have multi-step financing strategies and use both structured notes and high-yield debt to achieve their goals.
They might, for example, use structured notes to refinance high-yield debt or to pay it off when it reaches maturity.
At my bank, there are traders, bankers and salespeople that all fall into the SF group. The process starts with the bankers (my group) who “originate” business by pitching clients to issue MBS and ABS notes.
Once we win a mandate, we work with the rating agencies and lawyers to structure the deal. We get input from the sales force about investor demand for certain types of ABS throughout the process.
We talk to the traders as well to see where an issuer’s outstanding ABS notes might be trading to get additional color on any new issue pricing – and that’s how the bankers interact with the sales force and with traders.
Q: Thanks for that detailed overview of Structured Finance – it makes a lot more sense now.
What about the recruiting process? What should you expect in interviews?
A: Generally you get the same types of questions that you would get in any banking interview – accounting, valuation, and financial modeling, with the standard “fit” questions.
Most importantly, you need to understand what Structured Finance IS and know key buzzwords like “securitization” (the process of turning pools of loans into securities).
So do your homework on Structured Finance (everything above is a good start) and understand the types of assets that get securitized, the difference between an amortizing loan and a non-amortizing loan, and what makes an asset attractive or not attractive for securitization (hint: stable and predictable cash flows).
Your “story” is always important, and you need a solid reason for stating that you want to do Structured Finance – I can’t answer that one for you, but once you read part 2 of this interview you’ll get some more ideas.
One final point: recruiting, at least at my bank, is very heavily focused on only a few schools – our intern pool came from only 4 schools, so it’s even more limited than the usual “target school” selection.
That’s not to say you would be disqualified if you’re not coming from one of those schools (my alma mater isn’t on that list), but it certainly helps.
Q: It sounds very selective / random if they focus on only 4 schools.
What kinds of candidates are you looking for? Can undergraduates break in, or do you need more experience?
A: Most hires are straight out of undergraduate, but it’s such a niche area that there’s a premium for people who have experience.
There are only 10 or so banks with a strong presence in Structured Finance (you need a strong balance sheet, so pure-play investment banks aren’t market leaders), and generally the top 5 banks there look to hire undergrads and groom them to become future leaders, promoting them up the chain. They rarely make senior hires.
The bottom 5 banks in that group (anything smaller and more regional, and also a few European / Canadian / Other Foreign banks), by contrast, are constantly trying to poach talent from the top 5 banks and attempt to lure away senior bankers with more enticing pay packages.
You don’t need an MSF, MBA, or CFA to break in or to get promoted – few bankers here even have graduate degrees. They care 100x more about your practical experience and how well you understand Structured Finance than they do about your certifications.
We’re very focused on the “fit” of candidates, their relative intelligence, interest, and enthusiasm; just like in traditional investment banking, we spend countless hours with our colleagues… and we want to know that they’ll mesh with our group’s culture.
Q: So far it sounds much closer to a DCM or LevFin group in banking than a trading desk – what about an average day in your life, though?
Are you working market hours or banker hours?
A: Good question – that will have to wait until part 2 of this interview, where I tell you all about an average day in my life, the pay, my co-workers, exit opportunities and more!
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