Special Purpose Entity (SPE)
The special purpose entity [aka SPE, special investment vehicle (SIV), special purpose vehicle (SPV), special purpose corporation (SPC)] is a limited-purpose legal vehicle, organized as a corporation, limited liability company, or business trust, that is formed to securitize assets, such as loans and receivables, and sell them as asset-backed securities (ABS). Since most ABS are sold to institutional investors that require an investment grade credit rating, the SPE provides bankruptcy remoteness from the seller of the assets, which includes banks and finance companies, and allows the credit rating of the SPE to be higher than that of the seller or sponsor of the ABS. The SPE is simply a means of taking advantage of the laws that apply to companies or trusts so that it is treated as an independent entity, especially in regard to a possible bankruptcy of the SPV.
Bankruptcy remoteness is further secured by legally segregating the collateral from the originator or seller for the benefit of ABS holders. For bankruptcy remoteness to be legally effective, there must be a true sale of the assets at arm's length. The Uniform Commercial Code (UCC) of most states stipulates that this transfer can be accomplished either by transferring the loan documents from the seller to the SPE, or by filing a UCC finance statement. Filing UCC statements is usually done because it is cheaper and faster.
Legal counsel for the seller will render a legal opinion concerning the effectiveness of the transfer, including a true sale opinion and a nonconsolidation opinion, stating that if the sponsor enters bankruptcy, the assets of the SPE would not be consolidated with the assets of the sponsor.
After the special purpose entity is formed, the securitization of assets and their sale to investors involves the following steps:
- The assets, usually loans or receivables, are transferred from the seller to the SPE.
- The SPE securitizes the assets, then sells the resulting securities, mostly as notes, to investors.
- The proceeds of the security sale are then paid to the seller of the assets.
Credit rating agencies review all documents of the SPE before assigning a rating. While the credit rating agency is not a legal party to any of the agreements for setting up the special purpose entity, it is listed in the documents as the credit rating agency, and the documents also require that specified information be provided to the credit rating agency continually, to ensure that the proper procedures are being followed to maintain credit quality, and that the credit quality is actually being maintained.
Some of the legal documents used to form the SPE and to issue securities include:
- SPE organizational documents
- investment/portfolio management agreements
- trust agreements
- custodial agreements
- collateral, pooling, and servicing agreements
- loan and sale agreements
- mortgages or deeds of trust
- liquidity and credit support agreements
- swap agreements for converting floating and fixed rates
- legal opinions required by the credit rating agencies
- trust indenture and offering circular or prospectus for the securities
Subprime Mortgages Hurt Structured Investment Vehicles (SIVs)
Structured investment vehicles (SIVs) and securities arbitrage conduits make money by selling asset-backed commercial paper (ABCP), and using the proceeds to buy, among other assets, mortgage-backed securities (MBSs), profiting from the difference between the high interest rate received on the longer-term MBSs, and the lower interest rate paid on the commercial paper. However, commercial paper has a maximum maturity of 270 days, far less than most MBSs, so the SIVs have to sell more commercial paper to pay for the ones maturing. When the MBSs get downgraded because of their load of subprime mortgages, SIVs relying on MBSs get downgraded because of its riskier assets. Thus, even without defaults, it must pay a higher interest rate for its commercial paper, thus, eliminating its profits or even suffering losses. In extreme cases, it cannot even sell its commercial paper, forcing it to restructure or to turn to its sponsoring bank for financing. For instance, Axon Financial, Cheyne SIV, and OTTIMO Funding Ltd. were recently downgraded and forced to restructure because of their inability to sell their commercial paper in the money market.
Many funds are heavily invested in SIVs because they offered higher returns, and seemed very safe, but as more MBSs and other derivatives based on subprime mortgages get downgraded, the funds suffer as the SIVs suffer losses, prompting massive withdrawals from the funds by investors.