On SPV (FRM exam 2002, question 115)

[Liming]

Dear David,
I’ve have struggling with the following question from FRM practice and past exams. Appreciate your kind help on this!

14) On SPV (FRM exam 2002, question 115)
Finally, you are the risk manager for a pension fund considering the purchase of notes issued by the SPV. These notes earn LIBOR + 20 basis points. You are told that LIBOR + 20 basis points corresponds to what you would get by investing in a firm rated; but if the SPV had a rating it would be higher than A. Which of the following risks is not important?
a. The investment has oil-price risk, in that you could earn less than LIBOR + 20 basis points if oil prices fall sufficiently.
b. The value of the notes could fall below par if interest rates increase absent any deterioration of credit of the SPV.
c. The investment is exposed to the credit risk of the producer.
d. The investment is exposed to the credit risk of the affiliate that provides the credit guarantee.
Answer provided: b The value of the notes could fall below par if interest rates increase absent any deterioration of credit of the SPV.

My question: Why can’t we choose option c). Shouldn’t the credit risk of the underlying pool matter in a securitization and shouldn’t it be able to affect the value of the securitized notes?

Thank you for your enlightenment and correction!
Cheers
Liming
10/11/09

 

[David Harper CFA FRM]

Hi Liming,

I'm confused: the question says "not." Isn't that consistent with your view of (c).
Regardless, the question itself baffles me (oil?)

Re: "Shouldn’t the credit risk of the underlying pool matter in a securitization"
Yes, the notes are always exposed to the credit risk of the underlying pool (the credit sensitive assets): this is the definiton of risk transfer, the notes are "credit-linked notes"

but (c) says "the credit risk of the producer" and, I assume that refers to the originator (this question is a mess!)?

So, the better question is, are tranched note holders (who are clearly buying exposure to the assets) exposed to the credit risk of the originator?
That depends on the type of structured finance deal; if it is "merely" issuance of secured debt, then probably "yes."

But the use of an SPV implies a "true sale" securitization (i.e., assets have been transferred to the SPV corp or trusts). In a securitization, therefore, we typically assume the notes holder are *not* exposed to credit risk of originator. This is related to "bankruptcy remote:" creditors of the originator cannot claim the SPV assets in a bankcruptcy.

From Jorion handbook, Securitization: "A major advantage of this structure is that it shields the ABS investor from the credit risk of the originator. This requires, however, a clean sale of the assets to the SPV. Otherwise, the creditors of the originators might try to seize the SPV’s assets in a bankruptcy proceeding. Other advantages are that pooling offers"

(but otherwise, I personally would not get bogged down in this awkward question) - David