by Special Purpose Vehicle
A special purpose vehicle, also called a special purpose entity (SPE), is a subsidiary created by a parent company to isolate financial risk. Its legal status as a separate company makes its obligations secure even if the parent company goes bankrupt. For this reason, a special purpose vehicle is sometimes called a bankruptcy-remote entity.
Uses of Special Purpose Vehicles
- Securitization
Securitization of loans is a common reason to create an SPV. For example, when issuing mortgage-backed securities from a pool of mortgages, a bank can separate the loans from its other obligations by creating an SPV. The SPV allows investors in the mortgage-backed securities to receive payments for these loans before other creditors of the bank.
- Risk sharing
A corporation’s project may entail significant risks. Creating an SPV enables the corporation to legally isolate the risks of the project and then share this risk with other investors.
- Asset transfer
Certain types of assets can be hard to transfer. Thus, a company may create an SPV to own these assets. When they want to transfer the assets, they can simply sell the SPV as part of a merger and acquisition (M&A) process.
- Property sale
If the taxes on property sales are higher than the capital gain realized from the sale, a company may create an SPV that will own the properties for sale. It can then sell the SPV instead of the properties and pay tax on the capital gain from the sale instead of having to pay the property sales tax.
Benefits:
- Isolated financial risk
- Direct ownership of a specific asset
- Tax savings, if the vehicle is created in a tax haven such as the Cayman Islands
- Easy to create and set up the vehicle
Risks:
- Lower access to capital at the vehicle level (since it doesn’t have the same credit as the sponsor)
- Mark to Market accounting rules could be triggered if an asset is sold, significantly impacting the sponsor’s balance sheet
- Regulatory changes could cause serious problems for companies using these vehicles
- The optics surrounding SPVs are sometimes negative
Securitisable Assets
Debt
The advantage of a securitization transaction is that it enables the holder of the underlying debt to refinance that debt. Therefore, securitization involves assets that are typically illiquid (such as household debt), which are impossible to sell directly, since each individual debt is unique and requires separate administrative processing. Securitization also involves debts of smaller amounts, such as consumer debt, which, individually, generate relatively little income (in comparison to the amount of income typically generated by institutional investors) but which can be grouped together to make up a more valuable pool. Therefore, one of the main purposes of securitization is to create a marketable asset by combining several assets that, individually, are not as readily bought or sold, or in other words, to make a market for such assets.
Few examples of assets that can be securitized:
- Residential mortgage loans; this category includesthe infamous “subprime mortgages,” which are home loans issued to individualswith a low credit rating
- Commercial mortgage loans
- Bank loans to businesses
- Commercial debt
- Student loans (mainly in the US)
- Credit-card debt: in this case, the maturity of the security issued will typically be longer than that of the underlying debt; the assets portfolio will have to be “topped up” several times in order to ensure the promised cash flows. Therefore, some of the securitized debt does not exist yet at the time when the security is created. This is referred to as “securitization of future cash flows.”
- Automobile loans
Benefits of Securitization
Securitization, also known as asset-backed securitization or structured financing, has been defined as a financing instrument whereby a company transfers rights in current or future receivables or other financial assets to an entity that serves as a “special purpose vehicle” (SPV), which in turn issues securities to capital market investors and uses the proceeds from the issue to pay for the financial assets. The source of the receivables could be any right of payment or asset that generates an income with a stable cash flow. The existing or future receivables could be the income generated, among others things by residential or commercial loans, credit card receivables, automobile loans, student loans, royalties on intellectual property, tax receivables or any other income source that is regular and predictable.
Balance Sheet Benefits
Securitization accelerates cash receipts from the receivables while removing the accounts receivables from the originator’s balance sheet. This reduces the originator’s debt/equity ratio so that it is better able to:
(i) Comply with financial covenants in respect of its on-balance sheet borrowing;
(ii) Borrow more.
(iii) Improve the return on capital
The International Financial Reporting Standards (IFRS) (which replaced the International Accounting Standards (IAS)) have made securitization structures that allow an originator to remove receivables from its balance sheet harder to achieve. Whether or not these are applied, and the effect of other accountancy practices affecting off-balance sheet treatment, depends on the jurisdiction. However, balance sheet considerations continue to be an element of financial structuring.
Cheaper Financing
By using securitization techniques to separate a pool of underlying receivables, the originator may be able to generate a lower cost of financing than it can through various forms of borrowing. This is because receivables are often a better credit quality than the originator itself. Without securitization, the originator would finance itself through borrowing based on its own creditworthiness, therefore incurring additional debt. This “swapping” of one credit for another is known as credit arbitrage.
Capital Adequacy
In most jurisdictions, financial institutions must hold a minimum capital requirement (essentially equity, reserves and various forms of subordinated debt) against “risk-weighted” assets (that is, the value of assets taking into account a risk weighting which is based on the likelihood of the asset value being realized). The requirement is expressed as a ratio that is set by the relevant regulatory authority in a specific jurisdiction. The sale of receivables for cash effectively removes risk weighted assets from the regulated institution’s balance sheet and reports additional cash instead. This balance sheet “exchange” of receivables for cash improves regulated institution’s capital structure and reduces regulatory cost.
Alternative Source of Funding
Asset securitization provides the originator with additional source of funding or liquidity because this financing technique basically converts an illiquid asset (e.g. receivable deriving from a consumer loan which itself cannot be sold) into:
(i) Cash for the originator.
(ii) A security with greater marketability for investors.
Further, the ability to sell these securities worldwide diversifies the institution’s funding base, which reduces the institution’s dependence on local economies.
New Guidelines on Securitization
The RBI has also provided certain relaxations in relation to residential mortgage backed securities (RMBS) basis the recommendations of the Committee on Development of Housing Finance Securitisation Market in India. RMBS is defined as ‘securities issued by the special purpose entity against underlying exposures that are all residential mortgages’.
Under the Draft Securitisation Framework, the minimum holding period for RMBS will be six months or six instalments, whichever is later. The MRR for RMBS has been limited to 5% of the book value of the loans being securitised. If the value of the exposures underlying an RMBS is INR 500 crore or above, it is proposed that the securities issued must be mandatorily listed.
The revisions suggested, if given effect to, will enable HFCs and NBFCs with exposure to RMBS to package such portfolios and issue securities of different credit tranches and list them. Senior tranches can be issued to investors who are risk averse, while junior tranches can be issued to institutions who subscribe to such instruments. This will certainly provide the much-needed liquidity to HFCs and over time deepen the RMBS market and ensure that these products are available to a wider spectrum of investors.
Exemptions and Prohibitions
While the Draft Securitisation Framework now permits assets purchased from other entities to be securitised, resecuritisation exposures, synthetic securitisation and securitisation with revolving credit facilities as underlying continue to be prohibited. Pooling of purchased loans along with existing portfolios will increase the rating of certain kinds of pools.
Transactions involving revolving credit facilities, loans with bullet repayments of both principal and interest and securitisation exposures continue to be exempt from the applicability of the Draft Securitisation Framework.
Capital Requirement for securitisation exposures
The Draft Securitisation Framework provides for conditions required to be met by lenders for maintenance of capital. Such conditions will come into immediate effect and will apply to existing securitisation exposures as well. Conditions required to be met for de-recognition of the transferred asset by the originator include:
- Significant credit risk associated with the underlying exposures of the securities issued by the special purpose entity (SPE) being transferred to third parties. Significant credit risk will be treated as transferred if:
(i) There are at least three tranches, risk weighted exposure amounts of the mezzanine securitisation positions held by the originator do not exceed 50% of the risk weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation.
(ii) In cases where there are no mezzanine securitisation positions, the originator does not hold more than 20% of the exposure values of securitisation positions that are first loss positions.
- The transferred exposures are legally isolated from the originator and are put beyond the reach of the originator or its creditors;
- The securities issued by the SPE are not obligations of the originator;
- Securitisation does not contain clauses that require the originator to replenish or replace the underlying exposures to improve the credit quality of the pool, in the event of deterioration in the underlying credit quality.
Capital Measurement Approaches
In line with the Basel III guidelines, two capital measurement approaches have been proposed: Securitisation External Ratings Based Approach (SEC-ERBA) and Securitisation Standardised Approach (SEC-SA).
The Draft Securitisation Framework further provides that banks can adopt either of the two approaches. NBFCs (including housing finance companies) shall only apply the Securitisation External Ratings Based approach for calculation of risk weighted assets.
