Role of Special Purpose Role of Special Purpose Vehicles in ABS MarketVehicles in ABS Market

August 14August 14--18, 200618, 2006Shanghai, ChinaShanghai, China

NoritakaNoritaka AkamatsuAkamatsuThe World BankThe World Bank

SPV in Asset Securitization

Sponsor

Investor

Investor

Investor

Investor

SPV

Transfer ofassets

Securities ortrust certificates

Trustee

Sponsor could be at the same timea servicer especially if it is a bank.

Servicer

Securitiescompanies

Special Purpose Vehicle Special Purpose Vehicle (SPV)(SPV)

Legal entity functioning as a conduit with no physical Legal entity functioning as a conduit with no physical presence, independent management or employees.presence, independent management or employees.

It can take the form of limited partnership, limited It can take the form of limited partnership, limited liability company, trust, corporation, collective liability company, trust, corporation, collective investment fund or established under special law but investment fund or established under special law but only if those laws SPVonly if those laws SPV--enabling.enabling.

A subsidiary of the sponsor, or an OffA subsidiary of the sponsor, or an Off--B/S body not B/S body not consolidated with the sponsor for tax, accounting or consolidated with the sponsor for tax, accounting or legal purpose.legal purpose.–– The latter enables offThe latter enables off--balance sheet financing.balance sheet financing.

OffOff--B/S SPVB/S SPV

The transfer of assets from the sponsor to SPV must The transfer of assets from the sponsor to SPV must be be ““true saletrue sale”” to be offto be off--B/S.B/S.

Thinly capitalized.Thinly capitalized.

Administrative functions are performed by a trustee Administrative functions are performed by a trustee who follows prewho follows pre--specified rules regarding the receipt specified rules regarding the receipt and distribution of cash.and distribution of cash.

Assets held by SPV are serviced by a servicing Assets held by SPV are serviced by a servicing arrangement.arrangement.

Structured not to go bankrupt (Bankruptcy remote) Structured not to go bankrupt (Bankruptcy remote) despite the thin capitalization.despite the thin capitalization.

OffOff--B/S SPVB/S SPV

++ Enables the sponsor to remove debt from its B/S, Enables the sponsor to remove debt from its B/S, reduce the leverage and bankruptcy risk.reduce the leverage and bankruptcy risk.

++ It thus reduces the cost of capital (by reducing the It thus reduces the cost of capital (by reducing the expected cost of bankruptcy) and create additional expected cost of bankruptcy) and create additional room for financing for the Sponsor.room for financing for the Sponsor.

ButBut

-- But setting up an SPV involves costs though use of But setting up an SPV involves costs though use of master trust reduces those for large regular issuers.master trust reduces those for large regular issuers.

-- The sponsor loses tax advantage of carrying debt.The sponsor loses tax advantage of carrying debt.

-- It can also create prepayment risk for ABS which It can also create prepayment risk for ABS which investors will price to pass on to the sponsor.investors will price to pass on to the sponsor.

Cash flow manipulation and Cash flow manipulation and credit enhancementcredit enhancement

SPV facilitates cash flow manipulationSPV facilitates cash flow manipulation–– Cash flow Cash flow ““tranchingtranching”” enables creation of different classes enables creation of different classes

(seniority) of securities or beneficiary interest to best exploi(seniority) of securities or beneficiary interest to best exploit t market opportunities with senior notes creditmarket opportunities with senior notes credit--rated.rated.

Bearing of residual risk by the Sponsor enables credit Bearing of residual risk by the Sponsor enables credit enhancement of higher class notes. It can also enhancement of higher class notes. It can also discourage moral hazard by the Sponsor.discourage moral hazard by the Sponsor.

But it prevents the Sponsor to off load risky assets. But it prevents the Sponsor to off load risky assets. It can also raise a question about the true sale of the It can also raise a question about the true sale of the assets.assets.–– Collateral Investment Amount (CIA) and reserve accountCollateral Investment Amount (CIA) and reserve account

SPV facilitates credit SPV facilitates credit enhancementenhancement

Pooling of assets diversify their idiosyncratic risks Pooling of assets diversify their idiosyncratic risks and reduces the risk of potential adverse selection and reduces the risk of potential adverse selection by the Sponsorby the Sponsor

TranchingTranching also enables enhancement of the also enables enhancement of the creditworthiness of the senior creditworthiness of the senior tranchestranches. E.g.,. E.g.,–– A notes, B notes, which are typically creditA notes, B notes, which are typically credit--rated.rated.–– C notes (Collateral Investment Amount or CIA), which are C notes (Collateral Investment Amount or CIA), which are

typically privately placed.typically privately placed.–– Reserve account,Reserve account,

OverOver--collateralization,collateralization,

Letter of credit, Letter of credit,

guarantee by insurance company, guarantee by insurance company,

internal reserve fund, internal reserve fund,

Moral recourse and its Moral recourse and its implicationsimplications

The Sponsor also sometimes voluntarily provides the The Sponsor also sometimes voluntarily provides the SPV with moral recourse to its credit in the event of SPV with moral recourse to its credit in the event of major deterioration of the credit of SPV assets.major deterioration of the credit of SPV assets.

Market (and credit raters?) also expects that to some Market (and credit raters?) also expects that to some extent although such credit supports are not spelled extent although such credit supports are not spelled out in the contract.out in the contract.

Court may see it as an evidence of onCourt may see it as an evidence of on--B/S assets B/S assets and may not recognize the bankruptcy remoteness and may not recognize the bankruptcy remoteness of the SPV. of the SPV.

The failure to establish The failure to establish ““true saletrue sale”” of assets would of assets would lead to losses to the SPV beneficiaries in the event of lead to losses to the SPV beneficiaries in the event of the Sponsorthe Sponsor’’s bankruptcy.s bankruptcy.

““True saleTrue sale”” andand““bankruptcy remotenessbankruptcy remoteness””

Two key concepts of asset securitization.Two key concepts of asset securitization.

““True saleTrue sale”” ensures the SPV to be offensures the SPV to be off--B/S, i.e., the B/S, i.e., the beneficiariesbeneficiaries’’ rights over the assets held by SPV rights over the assets held by SPV should not be challenged by the third party.should not be challenged by the third party.–– When the Sponsor goes bankrupt, court may When the Sponsor goes bankrupt, court may recharacterizerecharacterize

the sale of assets to SPV as a secured transaction or the sale of assets to SPV as a secured transaction or consolidate the assets of the Sponsor and the SPV to consolidate the assets of the Sponsor and the SPV to protect the interest of creditors of the Sponsor.protect the interest of creditors of the Sponsor.

True sale must be established to ensure that True sale must be established to ensure that bankruptcy of the Sponsor have no implications on bankruptcy of the Sponsor have no implications on the SPV.the SPV.

True sale in the USTrue sale in the US

FAS 140, FAS 140, ““Accounting for Transfers and Servicing of Accounting for Transfers and Servicing of Financial Assets and Extinguishment of LiabilitiesFinancial Assets and Extinguishment of Liabilities””

SPV must be a SPV must be a ““qualifying SPV,qualifying SPV,”” i.e.,i.e.,Demonstrably distinct from the sponsor (i.e., cannot Demonstrably distinct from the sponsor (i.e., cannot unilaterally dissolve the SPV and at least 10% sold to the unilaterally dissolve the SPV and at least 10% sold to the unrelated third parties);unrelated third parties);Limited in its permitted activities specified by the legal Limited in its permitted activities specified by the legal documents defining its existence;documents defining its existence;Holds only passive receivables and makes no business Holds only passive receivables and makes no business decisions; anddecisions; andHas the right to sell or dispose of nonHas the right to sell or dispose of non--cash receivables only cash receivables only in automatic response to the occurrence of certain events.in automatic response to the occurrence of certain events.

The Sponsor must surrender The Sponsor must surrender ““controlcontrol”” of the of the receivables, i.e., have no ability to unilaterally cause receivables, i.e., have no ability to unilaterally cause the SPV to return specific assets.the SPV to return specific assets.

Variable Interest Entity (VIE)Variable Interest Entity (VIE)Lessons from EnronLessons from Enron

FASB struggled to define an SPV.FASB struggled to define an SPV.

New measures of financial control in the US, based New measures of financial control in the US, based not on voting rights but on the answers to the not on voting rights but on the answers to the following two questions:following two questions:–– Who holds the majority of the residual risk?Who holds the majority of the residual risk?–– Who obtains the majority of the benefit?Who obtains the majority of the benefit?

If the sponsor retains residual interest in an SPV, If the sponsor retains residual interest in an SPV, the SPV may be classified as the SPV may be classified as ““variable interest variable interest entity (VIE)entity (VIE)”” which fails to be a Qualifying SPV.which fails to be a Qualifying SPV.

SPV must be bankruptcy SPV must be bankruptcy remoteremote

Critical to avoid bankruptcy costs. The higher the Critical to avoid bankruptcy costs. The higher the SponsorSponsor’’s bankruptcy costs, the more useful SPV will s bankruptcy costs, the more useful SPV will be, especially when the Sponsor is risky.be, especially when the Sponsor is risky.

Bankruptcy of the sponsor should have no Bankruptcy of the sponsor should have no implications on the SPV.implications on the SPV.–– True sale is required.True sale is required.

SPV itself must be structured to ensure that it be SPV itself must be structured to ensure that it be unable to go bankrupt.unable to go bankrupt.–– Create SPV in a legal form that is ineligible to be a debtor Create SPV in a legal form that is ineligible to be a debtor

under the bankruptcy law.under the bankruptcy law.–– PassPass--through structurethrough structure–– Etc.Etc.

Bankruptcy remotenessBankruptcy remoteness–– continuedcontinued

Obtain agreements from its creditors that they will Obtain agreements from its creditors that they will not file involuntary petitions for bankruptcy.not file involuntary petitions for bankruptcy.

If corporation, the charter / byIf corporation, the charter / by--laws:laws:–– can be structured to require can be structured to require unanimityunanimity of votes by the of votes by the

board of directors to file a voluntary bankruptcy petition.board of directors to file a voluntary bankruptcy petition.–– have provisions that negate the boardhave provisions that negate the board’’s discretion unless s discretion unless

certain other criteria are met.certain other criteria are met.

Characteristics of bankruptcy Characteristics of bankruptcy remote SPV (S&Premote SPV (S&P’’s 2002)s 2002)

Restrictions on objectives, powers and purposes;Restrictions on objectives, powers and purposes;Limitations on ability to incur indebtedness;Limitations on ability to incur indebtedness;Restrictions or prohibitions on merger, consolidation, dissolutiRestrictions or prohibitions on merger, consolidation, dissolution, on, liquidation, winding up, asset sales, transfers of equity intereliquidation, winding up, asset sales, transfers of equity interest, st, and amendments to the organizational documents relating to and amendments to the organizational documents relating to separateness;separateness;Incorporation of separateness covenants restricting dealings witIncorporation of separateness covenants restricting dealings with h parents and affiliates;parents and affiliates;NonNon--petition language, i.e., a covenant not to file the SPV into petition language, i.e., a covenant not to file the SPV into involuntary bankruptcy;involuntary bankruptcy;Security interest over assets; andSecurity interest over assets; andAn independent director (or functional equivalent) whose An independent director (or functional equivalent) whose consent is required for the filing of a voluntary bankruptcy consent is required for the filing of a voluntary bankruptcy petition.petition.

Accounting & Taxation of Accounting & Taxation of SPVSPV

SPV is typically structured to be tax neutral; i.e., SPV is typically structured to be tax neutral; i.e., they are taxthey are tax--exempted and/or designed to have no exempted and/or designed to have no taxable income (e.g., passtaxable income (e.g., pass--through, paythrough, pay--through).through).–– If the tax neutrality is not achieved, the securitization If the tax neutrality is not achieved, the securitization

becomes too costly to be viable.becomes too costly to be viable.

Trust (special purpose trust or SPT) is popular form Trust (special purpose trust or SPT) is popular form of SPV in securitization partly because trust is not of SPV in securitization partly because trust is not taxable, having no legal personality and own income.taxable, having no legal personality and own income.–– The trustee should have no power to vary the investments The trustee should have no power to vary the investments

in the asset pool.in the asset pool.–– Its activities should be limited to conserving and protecting Its activities should be limited to conserving and protecting

the assets on behalf of the beneficiaries.the assets on behalf of the beneficiaries.

Problems sometimes found Problems sometimes found with SPTwith SPT

Is trust certificate recognized as Is trust certificate recognized as ““securitiessecurities”” under under Securities Law? If not, securities companies may not Securities Law? If not, securities companies may not be allowed to deal in the instruments.be allowed to deal in the instruments.

It may not be allowed to be traded in the regulated It may not be allowed to be traded in the regulated securities market such as a stock exchange.securities market such as a stock exchange.

Then, the instrument loses an important distribution Then, the instrument loses an important distribution channel and therefore attractiveness to its potential channel and therefore attractiveness to its potential investors.investors.

The lack of demand would discourage potential The lack of demand would discourage potential Sponsors to securitize in the first place.Sponsors to securitize in the first place.

Difficulties with Special Difficulties with Special Purpose Company (SPC)Purpose Company (SPC)Conventional company law typically does not enable Conventional company law typically does not enable SPC because it typically requires:SPC because it typically requires:–– Company have $X of capital to be established.Company have $X of capital to be established.–– Company issue securities to the public only after X years of Company issue securities to the public only after X years of

successful operation.successful operation.–– Shares of privately held company not be sold without Shares of privately held company not be sold without

consent of other shareholders.consent of other shareholders.

Conventional company is taxable.Conventional company is taxable.

Conventional company is not bankruptcy protected.Conventional company is not bankruptcy protected.

Need a special law to enable it? Or use collective Need a special law to enable it? Or use collective investment scheme under investment fund law?investment scheme under investment fund law?

Difficulties with Special Difficulties with Special Purpose Company (SPC) Purpose Company (SPC) –– 22

PayPay--through bonds are issued by SPC.through bonds are issued by SPC.

The residual (the sellerThe residual (the seller’’s interest) becomes s interest) becomes ““equityequity””of the seller, which would prevent the recognition of of the seller, which would prevent the recognition of true sale of the assets for tax purposes. true sale of the assets for tax purposes.

Legal frameworkLegal framework

Need a comprehensive review of the legal Need a comprehensive review of the legal framework surrounding the securitization process to framework surrounding the securitization process to see its feasibility. SPV sits in the kernel of the see its feasibility. SPV sits in the kernel of the securitization process.securitization process.

While the subject is technical, reforming various laws While the subject is technical, reforming various laws requires policy cooperation among various requires policy cooperation among various authorities.authorities.

The central bankThe central bank’’s leadership tends to be particularly s leadership tends to be particularly important. E.g., interest rate policy, rational important. E.g., interest rate policy, rational prudential rules for banks, etc.prudential rules for banks, etc.

Thank you.Thank you.