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Role of special purpose vehicles is ABS market


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Role of special purpose vehicles is ABS market

  1. 1. Role of Special Purpose Vehicles in ABS Market August 14-18, 2006 Shanghai, China Noritaka Akamatsu The World Bank
  2. 2. SPV in Asset Securitization Investor Trustee Securities or Transfer of trust certificates Investor assets Sponsor SPV Securities companies Investor Servicer Investor Sponsor could be at the same time a servicer especially if it is a bank.
  3. 3. Special Purpose Vehicle (SPV) Legal entity functioning as a conduit with no physical presence, independent management or employees. It can take the form of limited partnership, limited liability company, trust, corporation, collective investment fund or established under special law but only if those laws SPV-enabling. A subsidiary of the sponsor, or an Off-B/S body not consolidated with the sponsor for tax, accounting or legal purpose. – The latter enables off-balance sheet financing.
  4. 4. Off-B/S SPV The transfer of assets from the sponsor to SPV must be “true sale” to be off-B/S. Thinly capitalized. Administrative functions are performed by a trustee who follows pre-specified rules regarding the receipt and distribution of cash. Assets held by SPV are serviced by a servicing arrangement. Structured not to go bankrupt (Bankruptcy remote) despite the thin capitalization.
  5. 5. Off-B/S SPV + Enables the sponsor to remove debt from its B/S, reduce the leverage and bankruptcy risk. + It thus reduces the cost of capital (by reducing the expected cost of bankruptcy) and create additional room for financing for the Sponsor. But - But setting up an SPV involves costs though use of master trust reduces those for large regular issuers. - The sponsor loses tax advantage of carrying debt. - It can also create prepayment risk for ABS which investors will price to pass on to the sponsor.
  6. 6. Cash flow manipulation and credit enhancement SPV facilitates cash flow manipulation – Cash flow “tranching” enables creation of different classes (seniority) of securities or beneficiary interest to best exploit market opportunities with senior notes credit-rated. Bearing of residual risk by the Sponsor enables credit enhancement of higher class notes. It can also discourage moral hazard by the Sponsor. But it prevents the Sponsor to off load risky assets. It can also raise a question about the true sale of the assets. – Collateral Investment Amount (CIA) and reserve account
  7. 7. SPV facilitates credit enhancement Pooling of assets diversify their idiosyncratic risks and reduces the risk of potential adverse selection by the Sponsor Tranching also enables enhancement of the creditworthiness of the senior tranches. E.g., – A notes, B notes, which are typically credit-rated. – C notes (Collateral Investment Amount or CIA), which are typically privately placed. – Reserve account, Over-collateralization, Letter of credit, guarantee by insurance company, internal reserve fund,
  8. 8. Moral recourse and its implications The Sponsor also sometimes voluntarily provides the SPV with moral recourse to its credit in the event of major deterioration of the credit of SPV assets. Market (and credit raters?) also expects that to some extent although such credit supports are not spelled out in the contract. Court may see it as an evidence of on-B/S assets and may not recognize the bankruptcy remoteness of the SPV. The failure to establish “true sale” of assets would lead to losses to the SPV beneficiaries in the event of the Sponsor’s bankruptcy.
  9. 9. “True sale” and “bankruptcy remoteness” Two key concepts of asset securitization. “True sale” ensures the SPV to be off-B/S, i.e., the beneficiaries’ rights over the assets held by SPV should not be challenged by the third party. – When the Sponsor goes bankrupt, court may recharacterize the sale of assets to SPV as a secured transaction or consolidate the assets of the Sponsor and the SPV to protect the interest of creditors of the Sponsor. True sale must be established to ensure that bankruptcy of the Sponsor have no implications on the SPV.
  10. 10. True sale in the US FAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” SPV must be a “qualifying SPV,” i.e., Demonstrably distinct from the sponsor (i.e., cannot unilaterally dissolve the SPV and at least 10% sold to the unrelated third parties); Limited in its permitted activities specified by the legal documents defining its existence; Holds only passive receivables and makes no business decisions; and Has the right to sell or dispose of non-cash receivables only in automatic response to the occurrence of certain events. The Sponsor must surrender “control” of the receivables, i.e., have no ability to unilaterally cause the SPV to return specific assets.
  11. 11. Variable Interest Entity (VIE) Lessons from Enron FASB struggled to define an SPV. New measures of financial control in the US, based not on voting rights but on the answers to the following two questions: – Who holds the majority of the residual risk? – Who obtains the majority of the benefit? If the sponsor retains residual interest in an SPV, the SPV may be classified as “variable interest entity (VIE)” which fails to be a Qualifying SPV.
  12. 12. SPV must be bankruptcy remote Critical to avoid bankruptcy costs. The higher the Sponsor’s bankruptcy costs, the more useful SPV will be, especially when the Sponsor is risky. Bankruptcy of the sponsor should have no implications on the SPV. – True sale is required. SPV itself must be structured to ensure that it be unable to go bankrupt. – Create SPV in a legal form that is ineligible to be a debtor under the bankruptcy law. – Pass-through structure – Etc.
  13. 13. Bankruptcy remoteness – continued Obtain agreements from its creditors that they will not file involuntary petitions for bankruptcy. If corporation, the charter / by-laws: – can be structured to require unanimity of votes by the board of directors to file a voluntary bankruptcy petition. – have provisions that negate the board’s discretion unless certain other criteria are met.
  14. 14. Characteristics of bankruptcy remote SPV (S&P’s 2002) Restrictions on objectives, powers and purposes; Limitations on ability to incur indebtedness; Restrictions or prohibitions on merger, consolidation, dissolution, liquidation, winding up, asset sales, transfers of equity interest, and amendments to the organizational documents relating to separateness; Incorporation of separateness covenants restricting dealings with parents and affiliates; Non-petition language, i.e., a covenant not to file the SPV into involuntary bankruptcy; Security interest over assets; and An independent director (or functional equivalent) whose consent is required for the filing of a voluntary bankruptcy petition.
  15. 15. Accounting & Taxation of SPV SPV is typically structured to be tax neutral; i.e., they are tax-exempted and/or designed to have no taxable income (e.g., pass-through, pay-through). – If the tax neutrality is not achieved, the securitization becomes too costly to be viable. Trust (special purpose trust or SPT) is popular form of SPV in securitization partly because trust is not taxable, having no legal personality and own income. – The trustee should have no power to vary the investments in the asset pool. – Its activities should be limited to conserving and protecting the assets on behalf of the beneficiaries.
  16. 16. Problems sometimes found with SPT Is trust certificate recognized as “securities” under Securities Law? If not, securities companies may not be allowed to deal in the instruments. It may not be allowed to be traded in the regulated securities market such as a stock exchange. Then, the instrument loses an important distribution channel and therefore attractiveness to its potential investors. The lack of demand would discourage potential Sponsors to securitize in the first place.
  17. 17. Difficulties with Special Purpose Company (SPC) Conventional company law typically does not enable SPC because it typically requires: – Company have $X of capital to be established. – Company issue securities to the public only after X years of successful operation. – Shares of privately held company not be sold without consent of other shareholders. Conventional company is taxable. Conventional company is not bankruptcy protected. Need a special law to enable it? Or use collective investment scheme under investment fund law?
  18. 18. Difficulties with Special Purpose Company (SPC) – 2 Pay-through bonds are issued by SPC. The residual (the seller’s interest) becomes “equity” of the seller, which would prevent the recognition of true sale of the assets for tax purposes.
  19. 19. Legal framework Need a comprehensive review of the legal framework surrounding the securitization process to see its feasibility. SPV sits in the kernel of the securitization process. While the subject is technical, reforming various laws requires policy cooperation among various authorities. The central bank’s leadership tends to be particularly important. E.g., interest rate policy, rational prudential rules for banks, etc.
  20. 20. Thank you.