D.2 Creating an understanding of SPVs Flashcards

1
Q

How SPVs contributed to the 2007 subprime mortgage crisis

A
  • large amounts of subprime mortgages leading up to 2007

- mid-2007: real estate values begin falling = SPVs suffer heavy losses and affect solvency of many large institutions

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2
Q

features and uses of SPVs

A
  1. securitization of loans
    - sponsors can pool many loans together and sell tranches to investors as bonds
  2. Asset transfer
    - SPVs can contain assets that would be otherwise difficult to transfer
  3. Financing a parent company without directly investing in the parent company
  4. Risk sharing and relocation
    - sponsor can relocate risk to an SPV
    - SPVs are bankrupt remote
    - SPV has no legal connection to the sponsor
  5. financial engineering
    - abuse of SPVs can manipulate capital ratios and regulatory requirements, hide losses
  6. Raising Capital
    - SPVs can raise capital at a more favorable borrowing rate
    - Credit quality of SPV is based on the SPV assets, not the sponsor credit quality
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3
Q

SPV structure

A
  1. The sponsor creates an SPV
  2. the sponsor sells assets to the SPV, assets are now owned by the SPV
  3. SPV issues bonds to investors to finance the purchase of the assets
  4. the assets now reside in the SPV and are no longer on the sponsor balance sheet
  • an investment bank operates between the sponsor and the SPV
  • credit quality is based on the SPV assets, not the sponsor credit quality
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4
Q

Key SPV benefits to sponsoring firms

A
  1. Asset ownership - allows for ease of transfer between parties
  2. easy and cheap to establish
  3. easy to limit activities and prohibit transactions
  4. sponsor can incorporate an SPV in the most attractive jurisdiction from a regulatory perspective
  5. Tax benefits - SPV assets are exempt from certain direct taxes
  6. Legal protection - sponsor has limited legal liability for failed SPVs
  7. isolation of financial risks - SPV is bankrupt remote
  8. SPVs can help sponsor meet regulatory requirements easier by transferring certain assets off the balance sheet
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5
Q

key SPV risks to sponsoring firms

A
  1. lack of transparency - makes this difficult to manage risk
    - can have multiple layers of securitized assets
  2. reputational risk for the sponsor if the SPV fails
  3. poorly performing SPVs will reflect negatively on the sponsor
  4. poorly performing SPVs will damage sponsor relationship with investors
  5. poorly performing SPVs will affect the sponsors ability to raise more capital
  6. if the sponsor holds a large equity tranche in the SPV the firm may be taking on more risk than if the SPV asset were kept on the balance sheet
  7. forced sale of assets from an affiliated SPV can depress value of related assets on the sponsor balance sheet
  8. lax regulatory standards for SPV could cause the sponsor to create more risk in the SPV than if the assets had remained on the balance sheet
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6
Q

key SPV-related failures

A
  • Towers Financial
  • enron
  • Bear Sterns
  • Lehman Brothers

all used to hide debt, losses, and liabilities

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7
Q

Recent regulatory changes (SPVs)

A
  1. No longer automatic that an SPV asset can be held off balance sheet.
    - IFRS requires SPVs to be held on balance sheet if the sponsor effectively controls the SPV
  2. regulatory changes for SPVs
    - tightening of covenants in lending documentation
    - firmer legal risk management practices
    - increased emphasis on counterparty risks
  3. Basel III
    - require banks to hold more capital
    - supervisory review process for risk managment
    - enhanced risk disclosure
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8
Q

Managing the risks of SPVs

A
  • more governance based on the SPV complexity
  • reporting capability to assess and report SPV exposure
  • monitor quality of transferred exposures
  • regular oversight of SPV activity
  • market participants should be able to assess and risk manage factors that increase transaction capability
  • tighten reporting requirements
  • external regulators should not be allowed to provide consulting to the same clients they provide ratings for
  • simpler structures
  • standardize documentation and disclosures
  • Consolidate with sponsor for supervisory/risk management purposes if the sponsor provides financial support for SPV
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