Complex Debt Structures March 3rd, 2010 Structure of Asset Backed Securities Bank creates a special purpose vehicle. This requires legal documentation and a token level of equity e.g. 1 dollar. Think of this as akin to a mutual fund and its prospectus. The Bank structures the vehicle with its rules and does tests on the pools of receivables (loans). Typically, the value of the receivables exceeds the amount the bank will pay to the seller for the receivables. This is referred to as the over collateralization amount. The seller will eventually get the over collateralization amount back if the vehicle performs as is expected. Rules consist of what type of receivable is eligible – e.g. proper documentation, term of receivable, category of borrower, etc… . Rules dictate how and when ineligible receivables in the pool are replaced. The Bank asks Moody’s and or S&P to rate the structure. Rating agencies look at bank’s due diligence and description of the pool and rules and decide what the rating should be. There is also the performance risk which they must scrutinize. Very often the seller of the receivables retains the function of collecting the money from the receivables. Sometimes these funds go into bank accounts that of the seller that mix with other funds. This is called commingling risk since in bankruptcy if the funds are not completely separate at collection, the pool of funds can be awarded to all of the claimants in a bankruptcy case. The seller could be poor at sending out the bills on time and or cause other operational risks which can add to the total risk of the SPV. Structure continued Sometimes there can be different tranches of the special purpose vehicle. These tranches have different priorities in liquidation. For example the lowest tranche takes first loss while senior tranche only loses money if the bottom tranche or tranches are wiped out. Typically, the senior tranche will get a single A to AAA rating. Subordinated tranches do not typically get rated. The bank funds the special purpose vehicle by providing a bridge loan to purchase the assets. The bank then often gets taken out by having the SPV issue commercial paper. The bank however would normally provide a commercial paper back up facility for the special purpose vehicle. The vehicle then issues commercial paper to investors who are comforted by the public rating and the bank’s ability to fund them should the vehicle be short of cash. The commercial paper will of course carry the same rating as the vehicle (assuming there are no different tranches). The bank could also sell bonds in which case it would have no tie back to the SPV. Risks to Seller, Bank and Investor Seller could find that a lot of what they thought were eligible assets turn out to be ineligible. Therefore, they will be asked to take back the receivables (often these assets may be in or near default) which means the investor loses money on these even though they were technically sold. If there are too many, they may also be asked to increase the amount of over collateralization. Although they don’t necessarily lose money here, there are less receivables to be sold which means this action creates a bigger burden on the seller’s debt raising abilities (obviously “ineligible” receivables are of lower quality and if the seller is buying them back it means that what remains on the balance sheet is of poorer quality than what would be there if the seller didn’t sell receivables). The Bank could end up funding the SPV (lending money to it if the commercial paper investors decide they no longer want to fund the vehicle). The bank then gets stuck waiting for the portfolio to liquidate (in the case of car loans that could take 3 to 5 years). If of course the receivables continue to decline in quality, the bank will ask for replacement and/or increased number of receivables. However, if there are a huge number of bad receivables, the company (seller) may declare bankruptcy. If this happens, the bank will eventually lose money. Risks to Investor Commercial Paper Investors in vehicles that have bank back-up facilities shouldn’t lose money unless of course the bank fails to purchase the paper (i.e. the bank itself is insolvent). Only those investors who participate in SPV’s that are turned into bonds with differing tranches will lose money in a melt down situation. The lower tranches take the first losses while the senior tranche usually comes out without a loss. These latter pools are sold as straight term debt to investors. In such a case, there is no bank back up facility and the investor has in essence the same risk as the bank in the preceding bullet point. These types of SPV’s are called CDO’s (collateralized debt obligations). CDO’s also consist of CDO’s backed by CDO’s i.e. the CDO has as its underlying assets other CDO’s (like an investment fund that invests in other investment funds).