Special purpose entity

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A special purpose entity (SPE) (sometimes, especially in Europe, "special purpose vehicle" or simply SPV) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives. SPE's are typically used by companies to isolate the firm from financial risk. A company will transfer assets to the SPE for management or use the SPE to finance a large project thereby achieving a narrow set of goals without putting the entire firm at risk.

A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitization, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as 'orphan' companies with their shares settled on charitable trust and with professional board of directors provided by an administration company to ensure that there is no connection with the sponsor.

See also FAS 166, Mark-to-market accounting and SIV.

Contents

Overview of SPE

An SPE is a legal entity created at the direction of a sponsoring firm (which may also be referred to as the sponsor, originator, seller, or administrator). The sponsor is typically a major bank, finance company, investment bank or insurance company.

An SPE can take the form of a corporation, trust, partnership, corporation or a limited liability company. An SPE is a vehicle whose operations are typically limited to the acquisition and financing of specific assets or liabilities. In this respect, a distinction should be drawn between asset securitisations and liability securitisations. Asset securitisations are usually undertaken by banks and finance companies, and typically involve issuing bonds that are backed by the cashflows of income-generating assets (ranging from credit card receivables to residential mortgage loans).

Liability securitisations are usually undertaken by insurance companies, and typically involve issuing bonds that assume the risk of a potential insurance liability (ranging from a catastrophic natural event to an unexpected claims level on a certain product type).

The application of SPEs across financial sectors and to different asset classes is broad. For example, these structures are employed in programs for residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), asset-backed commercial paper (ABCP) programs, and structured investment vehicles (SIVs).

Repackaging vehicles are another significant business that involves SPE vehicles, one which permits clients to acquire tailored exposure to a variety of asset classes and risk profiles though a single instrument. For example, an investor that is seeking a structured return might request that a financial institution structure a transaction that combines otherwise unrelated credit components (exposure to one or more corporate entities), interest rate components (fixed, floating, inflation-linked, etc) and maturity components (bullet, scheduled maturity, etc) that are not currently available “packaged together” in the marketplace.

In contrast to asset securitisations, in the insurance sector institutions have used SPEs in products that transfer exposures to liabilities, such as bonds that transfer catastrophic event risk to the capital markets. Additionally, financial guaranty providers have created transformer structures that incorporate credit default swaps to provide the equivalent of guaranty insurance.

A defining feature common to many SPEs is that of bankruptcy remoteness, whereby an SPE’s assets are isolated from any creditors of its sponsoring firm should the latter go into bankruptcy. This feature can be achieved through a variety of methods, including limiting the SPE’s purpose, indebtedness, assets, and other liabilities (or non-financial obligations), as well as by ensuring through its corporate governance process that decisions regarding bankruptcy will be made from the point of view of the SPE itself (not its sponsor or other affiliate).

A “true sale” of assets from the sponsor’s balance sheet to such a bankruptcy remote SPE should ensure that the recourse of investors to assets held as security in the SPE is unlikely to be successfully challenged. In the US, the legal separateness of SPEs is considered fairly well established. However, bankruptcy remoteness may be harder to achieve in certain jurisdictions, or may be less certain where securitisation is a relatively recent development. These factors may explain why the use of SPEs is not as prevalent in such jurisdictions.

In some jurisdictions, most transactions involving SPEs are treated as on-balance sheet, while similar transactions in other countries will appear off-balance sheet. This distinction between on- and off-balance sheet treatment for accounting purposes, however, does factor into how transparent these vehicles have been in the international financial system.

Motivations

SPEs and the securitisation transactions that employ them can be viewed as a way of disaggregating the risks of an underlying pool of exposures held by the SPE and reallocating these risks to those parties most willing to take on those risks. This purpose is therefore a motivating factor for both originators and investors.

Originating or sponsoring institutions can use SPEs for risk management purposes, such as to transfer credit, interest rate, market, event, or insurance risks to other parties. Originators may also use SPEs to access additional sources of funding and liquidity, or to reduce funding costs. Smaller institutions may use SPE structures to pool exposures and thereby gain greater and more cost-effective access to the capital markets.

In some cases, sponsoring firms may be motivated to use SPEs to achieve off-balance sheet accounting treatment for assets, leading to improved financial and capital ratios for the firm.

Generally, off-balance sheet treatment is easier to achieve under US GAAP than under IFRS. However, recent changes to US accounting rules relating to SPEs that are effective in 2010 will significantly reduce the ability of certain transactions to qualify for off-balance sheet treatment.

Regulatory capital also serves as an important motivating factor for engaging in transactions involving SPEs. In particular, differences between the Basel I and Basel II regulatory capital frameworks present different incentives to enter into particular transactions. These differences manifest themselves along two dimensions. One is the difference in the treatment for on-balance sheet loans, and the second relates to differences in treatment of retained exposures in securitisation transactions.

Investors may be motivated to purchase securities issued by SPEs to gain exposure to new asset classes or possibly to avert regulatory and internal limits, such as those relating to name concentrations or credit quality. In the case of synthetic transactions, investors may find it beneficial that they would not have to fund credit exposures at the outset.

The relative importance of these motivating factors may vary across jurisdictions. For example, European financial firms generally have less ability to remove assets from their balance sheets by using SPEs. However, this is offset by the fact that risk-based capital requirements are not as closely tied to accounting in Europe. In contrast, while US firms currently can more easily remove assets from their balance sheets, the US implementation of Basel I required more capital for certain exposures than in Europe.

Risk Transfer

Vehicle types that tend to achieve a high level of risk transfer for originators include CDO/CLOs, SIVs (with notable exceptions), and RMBS structures. In contrast, high risk retention (implying a need for potential credit support on the part of the sponsor or originator) is generally more likely with programs such as covered bonds, certain ABCP conduits, and credit card securitisations.1

The current market crisis has highlighted several areas where firms may have misestimated the degree of risk transfer associated with certain SPE structures. Several factors will determine the level of risk transfer. One factor is whether the originator has retained a position in the capital structure and, if so, what position. The issue becomes more complex given that tranches initially retained at deal inception can be subsequently sold or else transformed through re-securitisation processes. Originating firms also have an asymmetric informational advantage in knowing more about the exposures than investors, which could potentially allow them to structure a deal to most efficiently transfer risk away from themselves.

Another important risk element relates to the existence of triggers in many structured finance transactions, such as early amortisation triggers in revolving securitisation structures and market value triggers in SIVs. Triggers may potentially be interrelated (as could happen in the case of re-securitisations, resulting in two layers of triggers) or else highly correlated (leading to procyclical effects). Beyond these contractual elements, considerations of factors such as reputational risk and franchise risk could lead originators to provide non-contractual support to investors in SPEs.

Abuses

Special purpose entities were one of the main tools used by executives at Enron, in order to hide losses and fabricate earnings, resulting in the Enron scandal of 2001. They were also used to hide losses and overstate earnings by executives at Tower Financial, which declared bankruptcy in 1994. Several executives of the company were found guilty of securities fraud, served prison sentences, and paid fines.

Accounting guidance

Under US GAAP, a number of accounting standards apply to SPEs, most notably FIN46R that sets out the consolidation treatment of these entities. There are a number of other standards that apply to different transactions with SPEs.

Under International Financial Reporting Standards (IFRS), the relevant standard is SIC12 (Consolidation—Special Purpose Entities).


References

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