SPVs, RMBS, and Covered Bonds

[avanbuiten]

Hello everyone. Here are some questions:

(1) If the assets beind a Residential Mortgage Backed Security are insufficient to meet repayments on bonds. Does the bond holder have a claim on any of the other assets that the SPV may own (I know they have no claim on original owner)? Or do they just miss out?
I know the notes say "bankrupt remote" but I can't work out if they mean the SPV as well as the original owner, or just the original owner?

(2) Covered bonds - does this mean bond holders also have a claim on other assets that belong to the original owner (the owner who sold assets to SPV)?

Thanks!!!

 

[Meldemon]

1) The SPV only has access to the cashflows from the mortgage, and not the actual property backing the mortgage. This remains with the bank that issued the loan. I am not quite sure what happens after the mortgage bank has repossessed the property to repay the loan.

The lower-rated tranches of bond are usually subordinate to the higher tranches, and will only get repaid from the SPV once the higher tranches are repaid. So AAA tranches will be repaid first, BB second and Junk last (if any cashflow is available to do so). If there is insufficient cashflow left the investors receive only a proportion of the settlement, e.g. 75 p in every pound or similar.

SPV's are also usually set up for a specific set of cashflows, so one block of mortgages should back only one set of mortgage backed securities, and a new SPV set up for every new set of securitisations (so if the cashflow runs out the SPV is "bankrupt" and will be shut down; investors have no further recourse to funds).

I also recall from an SA5 tutorial that the bonds in the lowest tranche get picked off randomly for settlement if the mortgages are repaid early. So these are therefore not spread accross all investors in the same proportion.

2) Got this from Wikipedia (see underlined bit) - I would be interested to hear if any of the tutors have a different opinion:

Covered bonds are debt securities backed by cash flows from mortgages or public sector loans. They are similar in many ways to asset-backed securities created in securitisation, but covered bond assets remain on the issuer’s consolidated balance sheet.

Essentially, a covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or "covers" the bond if the originator (usually a financial institution) becomes insolvent. This enhancement typically (although not always) results in the bonds' being assigned AAA credit ratings.

For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer's financials, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.

Another advantage is that the interest is paid from an identifiable source of projected cash flow versus out of other financing operations. Because non-performing loans or prematurely paid debt must be replaced in the pool, success of the product for the issuer depends on the institution's ability to evaluate the assets in the pool and to rate and price the bond.

 

[avanbuiten]

Thanks for the answer. So essentially you do have recourse to the assets of the SPV but in most instances there will be no other assets so it doesn't really matter.

And yes, with covered bonds you have recourse to the original owner.

 

[Meldemon]

Yes & Yes...

I think I now know why I always had time issues in the exams...

 

[NeedToQualify]

1) Are you sure the property security remains with the bank? It doesn't make sense, since the mortgage passes to the SPV and it's off the balance sheet of the bank.

 

[Meldemon]

It is usually the cashflows from the mortgages that go into the SPV rather than the property itself. The bank merely sells the cashflow through the SPV in order to raise capital from which to issue new mortgages. The mortgages holder still makes repayments to the bank directly and is unaware of the SPV even existing.

 

[NeedToQualify]

I agree that the bank still manages the assets, but the notes say that the assets are transfered to the SPV. Otherwise it wouldn't be bankruptcy remote.

 

[Meldemon]

I am not so sure, what about securitisation of future profits by e.g. a mobile phone company, selling future profits into an SPV to raise capital - surely the mobile phone contracts still remain with the mobile phone provider and don't transfer to the SPV? Similarly the mortgage agreement between bank and borrower can't change, only the bank (and not the SPV) has the right to reposess the house?

My reasoning is that by selling all cashflows into the SPV (including zero cashflows from defaults and proceeds from reposessions) the bank becomes a mere conduit of the SPV (see pass-through securities in the notes). As there is no further asset to the bank from the cashflows arising, and no credit risk on default of a borrower, the mortgages can be removed from the balance sheet.

The bankruptcy remote bit is done by merely stating that the SPV has only rights to the specified mortgage cashflows from the bank, and nothing else. If the SPV falls over, it is on its own and investors can't call on the bank to re-fund it.

I think 'asset' here is defined as a stream of cashflows rather than the mortgage as a whole. I would be surprised if the exam question drilled down to this level though...

 

[NeedToQualify]

yes it's probably too detailed...

just a note though...the point of being bankruptcy remote is that the SPV is not affected by the bankruptcy of the bank, which enables it to have a higher credit rating than the bank. So it protects the SPV investors rather than the bank (although it effectively works the other way round as well)

 

[Meldemon]

Yup, that's correct - helps protect the securitised bonds if the original lender runs into trouble (particularly relevant following last week's carnage on the markets)... could also help shore up credit ratings etc.

 

[avanbuiten]

The SPV may own the cashflows but the assets underlying the deal are still managed by the bank (original borrower). If the bank goes under, those cashflows are likely to be insufficient to repay the bond holders, who will lose out.

If the SPV goes under, the bond holders have no recourse to the bank's assets.

 

[Meldemon]

If the bank goes into liquidation the assets relating to the SPV cashflows should be ringfenced to service the SPV's requirements, i.e. the bank's other creditors will not have recourse to that particular stream of cashflows (remember that in this case the mortgages do not cease to exist, they are part of the administration process). Any residual assets after the bond tranches are repaid should then go to the equity tranche. Thus, the bankruptcy remote works in both directions.

Just to add to the confusion - the bank may buy back it's own securitisation's equity tranche on set up, effectively transferring that part of the risk back to the bank.

 

[MartingaleChase]

Quotes from Meldemon: The SPV only has access to the cashflows from the mortgage, and not the actual property backing the mortgage. This remains with the bank that issued the loan. I am not quite sure what happens after the mortgage bank has repossessed the property to repay the loan.

I don't agree with above as this would be POINTLESS for originator who uses SPV to carry on OFF BALANCE FINANCING and thus isolate itself from financial risk.

For accouting reason, originator typically takes only a partial ownership position in the SPV. Otherwise, there will be requirement for consolidating accounts if SPV is a wholly owned subsidiarly, which makes the deal really a on-balance sheet one and against the desire of setting up SPV.

The fact is that the "originator" DOES SELL those assets (collateral) to a SPV:

First, SPV now hold the assets on its balance sheet or place them in a separate trust. In either case, it sells bonds to investors. It uses the proceeds from those bond sales to pay the originator for the assets.

Second, originator will be continue to perform ongoing servicing activities (such as credit card receivables monthly bills sending etc) even after the assets have been securitised since it is is already performing servicing at the time of a securitization. Of course, it receives a small, ongoing servicing fee for doing so. Because of that fee income, servicing rights are valuable. The originator may sell servicing rights to a third party.

 

[Meldemon]

Few questions:

- If the originating bank only takes partial ownership in the SPV, who takes on the balance - the Investment Bank setting it up? How does the Investment Bank / majority stake holder avoid having to prepare consolidation accounts?

- If a bank has say 100 in mortgages issued to consumers, and then sells on all resulting cashflows of value 100 into a (bankruptcy remote) SPV - does this not effectively remove the risk from its balance sheet anyway? As all defaults are passed on to the SPV? (i.e. mortgage 'assets' = liability to SPV - does the bankruptcy remote feature not isolate the origintor from financial risk anyway).

- How do we avoid having to transfer mortgage contracts from the bank to the SPV - would mortgage consumers not need to agree / informed of the transfer and would doing so not hurt the reputation of the mortgage issuer? Consumers may see this as the loans 'being sold to a debt collection agency'.

- In accounting terms should the SPV not just show an asset = receivables from the mortgages (as mortage value = amount due to be received from mortgage holder).

... and by the way - no need to SHOUT ...

 

[Alpha9]

Here's how I see it.

Anyone can own (the equity in) the SPV: no reason for the bank (who set the mortgages, and separately the SPV, up) not to have a small or no part of the ownership. The (rest of the) equity could be sold to another party (somebody will have it at the right price).

I may be wrong here, but it seems to me that the assets that are sold to the SPV comprise both the payments by homeowners with mortgages, together with the proceeds of the sale of those properties should they be repossessed by the bank. The bank does the administration bit (collects mortgage payments, repossesses houses, sells repossessed properties, passes mortgage payments and resale proceeds to the SPV) having previously received from the SPV the proceeds of the bond sales.

So the bank has no net risk on its balance sheet: it has passed all this to the SPV. If a mortgage payer defaults, the bank's liability to the SPV reduces accordingly. And, if the bank doesn't own the SPV, the risk doesn't have to feature on a consolidated balance sheet either.

Meanwhile, on the SPV's balance sheet, the assets are as stated above, while the liabilities are the bonds and equity reserves. The problem for the SPV (and its debt- and equity-holders) is when the asset value falls: for instance, when a load of mortgages are defaulted on. Then the value of the assets falls below the value of the liabilities and the whole thing starts unraveling. Which I guess is where we are now.

Does that make any sense? I hope so; and maybe it'll come up next time, when I have to resit...