Exam 8: Why Do Financial Crises Occur and

Correct Answer:

Verified

The word "special purpose vehicle" or "special purpose entity" is a buzzword in structured finance and can be potentially confusing. Specially after the Enron collapse, the word SPE has acquired an unpleasant connotation in public mind.

The word "vehicle" is a marketplace equivalent of "entity". Therefore SPV and SPE mean the same thing. As opposed to a general purpose vehicle or a trading corporationg, a Special puropose vehicle, as the name suggests, is formed for a special purpose: therefore its powers are limited to what might be required to attain that purpose and its life is destined to end when the purpose is attained.

When a corporation, call it the sponsor of the SPV, wants to achieve a particular purpose, for example, funding, by isolating an activity, asset or operation from the rest of the sponsor's business, it hives off such asset, activity or operation into the vehicle by forming it as a special purpose vehicle. This isolation is important for external investors whose interest is backed by such hived-off assets,etc., but who are not affected by the generic business risks of the entity of the originating entity. Thus SPVs are housing devices - they house the assets etc transferred by the originating entity in a legal outfit, which is legally distanced from the originator, and yet self-substained as not to be treated as the baby of the originator.

By its very nature, an SPV must be distanced from the sponsor both in terms of management and ownership, because if the SPV were to be owned or controlled by the sponsor, there is no difference between a subsidiary and an SPV.

Collateralized debt obligations, or CDOs, are structured vehicles that are similar to leveraged closed-end funds. As discussed below, the majority are cash flow structures, a fair number are synthetic structures, and some use a market value structure. A majority of all CDOs are actively managed and invested in different asset classes. At the core of the CDO is a bankruptcy-remote, special-purpose entity (SPE) that issues securities to investors in the form of several classes that are tranched into differently rated and some unrated securities. Each class of securities represents a different level of risk and reward associated with the asset pool. The most senior securities have credit ratings higher than the average ratings of the collateral pool, with lower tranches being rated below the seniors. The first-loss tranche is equity (or preferred shares) that is typically not rated.