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With this spring’s criminal trial of former Enron executives Ken Lay and Jeffrey Skilling, the public was again seeing accounts of Raptors, Chewco and Osprey — some of the shadowy “special purpose vehicles” the energy company used for improper purposes such as concealing its mushrooming debt.
But while much of Enron’s SPV use was illegal, most SPVs are proper and they can serve a variety of functions. Many are separate business-financing operations whose transactions do not appear on the parent company’s books. They can be used to create easily traded asset-backed securities that allow their “sponsor” companies to convert cash flows expected over many years into immediate lump-sum payments, says Gary B. Gorton, professor of banking and finance at Wharton.
Indeed, use of SPVs is enormous. It involves a range of securities backed by assets such as cash flow on car loans, credit-card and home-equity debt, manufactured-housing loans, student loans and equipment leases. Publicly reported SPVs, measurable because they are assessed by rating agencies, issued about $800 billion in asset-backed securities in 2005, according to Gorton. That was about $200 billion more than was issued through conventional corporate bonds. The total value of such SPV-related securities outstanding soared from less than $400 billion in 1995 to nearly $1.8 trillion early in 2004, not including the more familiar mortgage backed securities and collateralized debt obligations.
In addition, there is a huge SPV market that goes unmeasured because the products are privately traded and not rated. Though Enron’s unrated special purpose vehicles broke the rules, many other companies used such vehicles to legally conduct “off-balance sheet” transactions. “That stuff — we just don’t know how big it is,” Gorton says.
Why does a company set up a special vehicle for tasks like issuing asset-backed securities instead of doing the work itself? Business people who use SPVs say sponsoring companies get cheaper financing this way than they can get on their own, while offering investors greater safety and better returns than they would get if they lent directly to the sponsors, Gorton says.
But is this really the case? And if it is, why? Perhaps there are factors even the SPV industry does not fully understand. “The large issues in the economy that are motivating people are not something that people are necessarily aware of,” Gorton notes.
The industry’s roots go back several decades to the “securitization” of mortgage debt by Fannie Mae and Freddie Mac, the government-sponsored mortgage providers. In this process, a large number of mortgages are bundled together and sold to investors in the form of bonds. The investors then receive the interest and principal payments made by the homeowners. In the 1980s, similar securitization was used when the government took over and then resold assets — such as the expected cash flow from loans — of failed savings and loans.
In both cases, the process provides financing for the sponsor, which by selling securities receives an immediate sum rather than having to wait years to get loan payments from borrowers. At the same time, the sponsor remains in control of the business — deciding, for example, which applicants to approve. Investors who buy the SPV securities receive interest payments, just as they would with any type of bond, in exchange for taking on the risk that borrowers such as homeowners or credit card users default on their loan payments.
Watching these two examples, others saw opportunities to securitize all sorts of cash flows, Gorton says. In one of the most innovative cases, singer David Bowie sold $55 million worth of “Bowie Bonds,” giving investors the right to share in future royalties from his early albums.
Insulated from Risk
For a clearer picture of the forces driving this type of special purpose vehicle, Gorton and Nicholas S. Souleles, a finance professor at Wharton, looked at the largest sampling ever studied — credit-card securities rated by Moody’s Investors Service from mid-1988 through mid-1999. The results are reported in their paper titled, “Special Purpose Vehicles and Securitization.”
Each credit card user is obligated to make monthly payments on account balances to the bank or other entity that issued the card. The issuer sets up an SPV and sells it the right to receive card payments. The SPV bundles those rights into a form of bond which is sold to investors. The investors thus receive the interest and principal payments.
The SPV, Gorton says, “is essentially kind of a robot firm. It’s not really going to do anything. Nobody works there. It doesn’t have a physical location.” Legally, SPVs can be limited partnerships, limited liability companies, trusts or corporations. They have no decision-making powers and all their actions are governed by strict rules written by the sponsor. In addition to securitizations, they may be formed to conduct research and development, engage in lease transactions or perform other functions.
By bundling card debt and selling it to investors, the card issuer generates cash that allows it to make more loans. But there is a particular advantage to doing this through a special purpose vehicle, Gorton says. “Basically, what we end up saying is that there’s a kind of fundamental reason that this happens. We think that it has to do with the bankruptcy code and what happens when companies go into bankruptcy.”
SPVs, he notes, are set up so that they cannot declare bankruptcy and so their assets cannot be seized if their sponsor goes bankrupt. Investors in SPV securities are therefore insulated from the risks they would shoulder dealing directly with the sponsor, which could get into financial trouble in any number of ways not directly related to its credit card business. In the worst case, the SPV’s assets — the right to receive credit card payments — are simply distributed to the investors holding the securities. “The holders of the bonds have always gotten their principal back,” says Gorton.
The only downside for bondholders is that if something goes wrong, they get principal back sooner than expected, so they miss anticipated interest payments. This is troublesome if prevailing rates have fallen and they must reinvest their principal at lower yields, but it’s far preferable to risking principal, or shouldering the expense of recovering principal in a bankruptcy.
Because of this bankruptcy insulation, SPVs can receive better credit ratings than their sponsor companies and therefore can issue securities that pay less interest than the sponsor would have to pay if it issued the securities itself. By using SPVs, the sponsor company thus finances its operations at lower rates than it could on its own. Investors earn less than they would if the securities were issued by the sponsor, but this is offset by the lower risk.
Getting these benefits from SPVs is tricky. Despite the insulation, investors want some assurance that the sponsor stands behind the SPV if it gets into financial trouble — if cash flows fall short of expectations, for example. But the sponsor cannot explicitly promise to step in and bail out an SPV because that would make the transfer of assets from sponsor to SPV a loan rather than a sale, changing the accounting and eliminating the valuable bankruptcy insulation.
“What apparently happened over the years was that in order to make this market work and get the benefits of avoiding the bankruptcy problem, companies did support their entities when they got into trouble,” Gorton says. “We basically think that there’s an implicit contract between investors and [the sponsor] which says that if anything goes wrong, don’t worry, we’ll fix it. Everyone knows it’s there, but they can’t write it down.”
To see if this was true, Gorton and Souleles looked at SPV-issued securities that were identical in all respects but one: One set was issued by SPVs created by sponsors with excellent credit ratings; the other by sponsors with poorer ratings.
Gorton and Souleles found that the second group carried yields of nearly half a percentage point higher than those associated with the higher-rated sponsor. In other words, investors who bought the bonds associated with the poorly rated sponsor earned nearly half a percentage point more interest per year.
Since all other factors were equal, this higher yield had to reflect investors’ concern that there was a greater risk the low-rated sponsor would fail and not be around to bail out its SPV if something went wrong. At the same time, investors must have believed the higher-rated sponsor would step in to help its SPV if necessary. Thus, investors clearly had an implicit understanding that sponsors intend to back their SPVs even though this is not explicitly guaranteed.
The difference in yields — nearly half a percentage point — was large enough to signify that the market places a very high value on sponsors’ implicit backing of SPVs, Gorton says. “That’s an economically big number. People were stunned by that.” The study also found that sponsors with a higher risk of bankruptcy were more likely to use SPVs for financing, since they stood to benefit more from the lower financing cost produced by SPV bankruptcy insulation.
The Enron case left many people with a bad impression of special purpose vehicles, since that company used them to improperly hide its financial problems from shareholders and regulators. But when used properly, SPVs can benefit the broad economy as well as the sponsoring companies. SPVs allow lenders and other businesses to shift risks to investors willing to shoulder it, Gorton says. “If you spread risks, you don’t have risks concentrated in the banking system,” he says, adding that the sponsor’s implicit guarantees help make this market possible.