In achieving the benefits associated with a securitization, why is the special purpose vehicle important to the transaction?

What will be an ideal response?

To understand the role of the special purpose vehicle (SPV) and the benefit derived from it, we need to understand why a corporation would want to raise funds via securitization rather than simply issue corporate bonds. There are four principal reasons why a corporation may elect to raise funds via a securitization rather than a corporate bond. They are the potential to reduce funding costs, to diversify funding sources, to accelerate earnings for financial reporting purposes, and to achieve (if a regulated entity) relief from capital requirements.

Let us focus on the first of these reasons to understand the critical role of the SPV in
a securitization. Suppose that Exceptional Dental Equipment, Inc. (EDE) has a BB credit rating. If it wants to raise funds equal to $300 million by issuing a corporate bond, its funding cost the going rate for a firm with a BB credit rating. If EDE defaults on any of its outstanding debt, the creditors will go after all of its assets, including the loans to its customers.

Suppose that EDE can create a legal entity and sell the loans to that entity. That entity is the special purpose vehicle (SPV). In our illustration, let us call the SPV by the name of DEAT. If the sale of the loans by EDE to DEAT is done properly, DEAT then legally owns the receivables, not EDE. As a result, if EDE is ever forced into bankruptcy while the loans sold to DEAT are still outstanding, the creditors of EDE cannot recover the loans because they are legally owned by DEAT.

The legal implication is that when DEAT issues the ABS that are backed by the loans, investors contemplating the purchase of any bond class will evaluate the credit risk associated with collecting the payments due on the loans independent of the credit rating of EDE. The credit rating will be assigned to the different bond classes created in the securitization and will depend on how the rating agencies will evaluate the credit risk based on the collateral (i.e., the loans). In turn, this will depend on the credit enhancement for each bond class. So, due to the SPV, quality of the collateral, and credit enhancement, a corporation can raise funds via a securitization where some of the bond classes have a credit rating better than the corporation seeking to raise funds and that in the aggregate the funding cost is less than issuing corporate bonds.