Role of Special Purpose
Vehicles in ABS Market
August 14-18, 2006
The World Bank
SPV in Asset Securitization
trust certificates Investor
Sponsor SPV Securities
Sponsor could be at the same time
a servicer especially if it is a bank.
Special Purpose Vehicle
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
– The latter enables off-balance sheet financing.
The transfer of assets from the sponsor to SPV must
be “true sale” to be off-B/S.
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
Structured not to go bankrupt (Bankruptcy remote)
despite the thin capitalization.
+ 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 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.
Cash flow manipulation and
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
– Collateral Investment Amount (CIA) and reserve account
SPV facilitates credit
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,
Letter of credit,
guarantee by insurance company,
internal reserve fund,
Moral recourse and its
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.
“True sale” and
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
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
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.
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.
SPV must be bankruptcy
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
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.
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
Incorporation of separateness covenants restricting dealings with
parents and affiliates;
Non-petition language, i.e., a covenant not to file the SPV into
Security interest over assets; and
An independent director (or functional equivalent) whose
consent is required for the filing of a voluntary bankruptcy
Accounting & Taxation of
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.
Problems sometimes found
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
The lack of demand would discourage potential
Sponsors to securitize in the first place.
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
– 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?
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.
Need a comprehensive review of the legal
framework surrounding the securitization process to
see its feasibility. SPV sits in the kernel of the
While the subject is technical, reforming various laws
requires policy cooperation among various
The central bank’s leadership tends to be particularly
important. E.g., interest rate policy, rational
prudential rules for banks, etc.