SPVs and DPCs

[Bucephalus]

Hi All, newbie here

My first question is on SPVs and DPCs (I couldnt find a relevant thread and hence starting a new thread). Although, the two are largely irrelevant in today's market, I have the following questions on them:

1. It is mentioned that SPVs and DPCs are rated separately by the credit agencies. What is the mechanism to rate the SPVs and DPCs?
2. I understand that the capital allocation for these entities is off-balance. Will the liabilities (for example, principal of a bond) account for the capital allocation to these entities?

Thanks!

 

[Bucephalus]

@Nicole Seaman , @David Harper CFA FRM ..Can you please help?

 

[Nicole Seaman]

@Nicole Seaman , @David Harper CFA FRM ..Can you please help?

@Bucephalus

I'm sure David or another member will be able to answer your question shortly. Our forum is very busy, and answers are not always provided immediately. Have you used the search function in the forum to search for keywords related to your question? This may help while you are waiting for an answer

Thank you,

Nicole

 

[Bucephalus]

Yes @Nicole Seaman .. I created the thread after searching the forum. If you do find a relevant thread, please let me know.

 

[David Harper CFA FRM]

Hi @Bucephalus I'm sorry for the delay (... have been busy updating videos....). Newbie? Welcome In regard to your questions:

1. Methods can vary but the one which has been featured in the FRM is illustrated in the P2.R49 reading (by Ashcraft, a copy is here: http://trtl.bz/R49-P2-T6-Ashcraft-subprime. It happens to be the case that Deepa has drafted an update of the corresponding study note and we will be publishing the final this upcoming week.). The reason that "methods can vary" is that the SPV is a company (entity) with its own balance sheet, so its liabilities (debt) can be credit analyzed, in theory, variously but just like a company. But we tend to associate the SPV with its role in a securitization where its assets are funded by tranched liabilities issued to investors. (analogous to a company balance sheet: a company issues senior debt, and an securitization will issue senior bond/security to investors). The basic mechanism reviewed in Ashcraft (see snapshot of our XLS below) depends on specifying a loss distribution that relates the level of credit enhancement (CE) to default probability (PD); i.e., "In the first step of the rating process, the rating agency estimates the loss distribution associated with a given pool of collateral. The mean of the loss distribution is measured through the construction of a baseline frequency of foreclosure and loss severity for each loan that depends on the characteristics of the loan and local area economic conditions. The distribution of losses is constructed by estimating the sensitivity of losses to local area economic conditions for each mortgage loan, and then simulating future paths of local area economic conditions." This begs the question of, how to map the rating to a PD?, but the primary driver in a securitization SPV would be the credit enhancement (i.e., over-collateralization + subordinated tranches) as they represent the protection against losses.
   
2. If I understand you, then I think the answer is: Yes. There are, in fact, degrees of securitization. The most basic ("purest") is a so-called "true sale" of the credit-sensitive assets, by the originator to the SPE. This would remove the assets from the originator's balance sheet and locate them in the (bankruptcy remote) SPV. The SPV is a legal entity (company) with its own balance sheet. It will issue liabilities to the investors; e.g., senior tranche. So to your point, investors will (via their purchase) provide the capital (liabilities on the SPV's balance sheet). In this cash securitization, the originator is removed from the picture and the SPV is a company with credit sensitive assets that are claimed by liabilities in the form of tranched notes issued to investors. The originator effectively receives the investor's cash so in this purest securitization, the originator has swapped credit-sensitive assets for cash and, critically, removed (transferred) the credit risk off its balance sheet. This is a whole topic unto itself complete with updating legal/accounting issues: the originator can securitize in other "less-pure" ways to transfer the credit risk less robustly, but also seek to reduce it's obligation to hold capital against the exposures. And, of course, the originator can securitize but retain some tranche(s), and then those would be subject to capital requirements for securitization exposures (a sub-topic in Basel, with evolving rules!). I hope that's helpful!

 

[Bucephalus]

That was very informative as usual @David Harper CFA FRM . Thank you!