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Taking the toxic element out of SPEs?

Finance Blogger: Anthony Harrington Anthony Harrington

One reason why the regulators had no visibility of just how badly the banking sector had over-leveraged itself across the developed world prior to the 2008/2009 crash, was the excessive use of special purpose entities (SPEs) by the banks.

The SPEs made many transactions look “arm’s length,” and not part of a bank’s trading book, that were actually nothing of the kind. Inevitably, as part of its “rethink” on the regulatory framework the Basel Committee has had to wrestle a few rounds with the SPE monster.

As any corporate lawyer will tell you, while struggling to hide the smirk, there is nothing essentially malevolent about an SPE. You want to do a project a little out your ordinary line of business. I want to get involved too. We set up an SPE structure and it sits to one side of both our businesses, which run as usual. That’s fine and dandy until you or I want to borrow money for our mainstream business and the SPE turns out to be invisible to the potential creditor.

Once that happens, the creditor has no idea how much risk either of us is running in the SPE or even that the SPE exists, if we don’t disclose it. It might be a massive project, the failure of which could sink either or both of us. In that frame, the SPE is highly toxic to the creditor. Of course, with ordinary borrowers, the lender’s documentation would certainly require disclosure of anything material and not disclosing the SPE would be fraudulent.

If, however, our businesses were enormous with large numbers of SPEs, some of which were invested, in their turn, in other of these SPEs, or worse, in some other parties’ SPEs, disclosure would not guarantee visibility. The material risk could easily be lost in the clutter. This was one of the building blocks that allowed Enron to construct structures that were completely opaque to outsiders (and to many Enron insiders as it later turned out). It was also one of the reasons why tracking systemic risk across the financial sector was next to impossible prior to the crash.

The general purpose of an SPE, which can take any of several forms, from a trust or partnership to a limited liability company, is to acquire or finance specific assets and liabilities. Prior to the crash, SPEs were used extensively to carry out asset and liability securitization. The now infamous residential mortgage-backed (read sub-prime) securities (RMBS), which were bundled up into collateralized debt obligations (CDOs) and which wreaked havoc on investors, were put to the market through SPEs.

They are also extremely useful for giving clients of investment banks and the banks themselves tailored exposure to a variety of asset classes and risk profiles. One of the main points of an SPE is “bankruptcy remoteness,” which means that the assets of the SPE are protected should the sponsoring organization (the originator of the SPE) fail. From an investor’s point of view, this is a very good thing, so, to reiterate, SPEs are not bad in and of themselves.

In its paper on SPEs [PDF, 468 KB] the Joint Forum of the Basel Committee has two objectives. First, it wants to contribute to the understanding of SPEs and their uses and the paper is admirably clear in this regard. Second, it aims “to inform [bank] supervisors and other market participants of the benefits and risks associated with the use of SPEs.” The financial community thought it understood the benefits of SPEs. It has just had a very forthright and brutal lesson in the risks involved. Quite what the supervisors and regulators will make of such a double-edged sword going forward remains to be seen.

Further reading for special purpose entities

Tags: Basel Committee on Banking Supervision , financial crisis , securitization , special purpose entities , transparency
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