We continue to note a growth in the number of Special Purpose Vehicles in the market, the majority of which (but not all) are sponsored by banks and brokers. We present here some analysis on the industry and how these vehicles are operating.
The rationale for a growth in Special Purpose Vehicles (SPVs) is the need for funding. As repo is constrained by the Leverage Ratio, bilateral OTC derivatives carry higher balance sheet charges and securities lending has multiple challenges, SPVs and similar products offer an opportunity to push collateral to a cash provider. Its the same economic rationale as physical financing only it has a wrapper.
These SPVs are arriving under a variety of names. Collateralized Commercial Paper has been around for a couple of years but growth appears to be stalled due to uncertainty about the collateral and what happens in case of default. However, SPVs, Business Development Corporations and Funding Notes are going strong; just don’t call them Structured Investment Vehicles (SIVs). We also see Total Return Swaps with the same economic purpose. We wouldn’t go so far as to call this regulatory arbitrage, but it is a direct response to the pressures that regulations have put on previously established financing methods.
Our first thought in looking at these vehicles was that they weren’t so great – that they would be an off-balance sheet liability to the issuer and negatively impact the Leverage Ratio. We then learned that banks are fully capitalizing these vehicles so they have assets to balance out the liability. While this requires firm capital, it apparently is a better option than the hit to the denominator of the Leverage Ratio.
Pushing out unfunded positions is often the first objective of these vehicles but they are starting to serve another purpose as well: soaking up hot cash. It has become cost-prohibitive for brokers to keep hedge fund cash on their balance sheets (not to mention the problems that custodians have). That cash has to get invested somewhere. These new SPVs can take up hedge fund cash in a structured product that serves an equal value to the broker of getting their assets funded. For broker-issuers, this is a win-win.
Is the collateral in these new products safe? In truth, there is no way to tell on a daily basis without direct access to the trustee or custodian that holds the collateral safely. We did find in a recent analysis on ABCP that the parent bank guarantee is often much more important than the collateral that funds an asset. Ratings help too, useless as they may be owing to no look-through to the collateral. As a result of the guarantee and rating, the collateral behind these SPVs could sometimes be entirely toxic and it wouldn’t matter. Investors would still buy them. This seems like a dumb idea to us but it is what we see happening.
We also see collateral quality being effectively not valued or barely valued in some of these transactions. We would expect that structured products require a buyer premium for complexity over unstructured, and that a bank guarantee would push pricing down. We would further expect that high quality collateral would reduce the cost. This is not what we are seeing in practice, although arguably the available data on collateral do not support a robust analysis. Instead, pricing seems to be based on ratings and the issuer guarantee, all but ignoring the underlying collateral.
The growth in SPVs currently backed by a wide mix of uncertain collateral suggests an inefficient market that benefits issuers. Banks are benefiting from getting their assets financed while providing hedge funds an investment vehicle for hot cash. A bank guarantee is covering over some of the ugly spots that may appear on these products. They serve a purpose and benefit issuers, but buyers should pay close attention to what they are getting in return.