Session 26 - Securitization Accounting 2 (2)

Session 26 - Securitization Accounting 2 (2) -...

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Securitization and Special Purpose Entities: Background Step 2 $100 million auto receivables $100 million note payable Step 4 $100 million note repaid $96 million cash, $4 million retained interest Step 1 Step 3 $100 million $100 million in $96 million cash $96 million of cash 7% auto receivables 5 1/2 % notes payable Simplified Example of a Securitization Pool Special purpose entities (SPEs) are legal organizations formed by an originator to complete a specific objective or activity. The legal entity might be a limited liability corporation (LLC), a limited partnership, a trust, or a corporation. The originator, sponsor, or beneficial interest might be a automobile financing subsidiary or a firm such as Enron. The SPE's objective or activity might be: (1) purchase receivables from the sponsor, and then sell the cash flow rights to outside investors; (2) purchase a building or equipment that will be "leased" to the sponsor. The most common SPE form is a securitization pool. GMAC or Toyota Finance might sell $100 million of automobile receivables to an SPE, which would then sell interests to institutional investors, such as insurance companies and banks. Firms also routinely securitize home mortgages, future credit card payments, auto loans, and similar debt. That provides a highly efficient way for institutional investors with excess funds to lend to those who need funds. Suppose Toyota Finance (TF) makes (originates) $100 million of 7% automobile loans to customers who purchase new Toyotas (Step 1). If it held those receivables, TF would need to raise substantial funds and would be exposed to significant interest rate and credit risk. Instead, TF sells the receivables to a SPE, as shown in the following simplified example. The transaction is slightly more complicated to ensure that TF creditors have no legal claim to the receivables in the SPE in the unlikely event that TF declared bankruptcy. After TF makes the loans, it sells them to the SPE for a note (Step 2). The SPE then sells marketable notes to institutional investors (Step 3). Since those investors have no right to seek payment from TF, they require protection. They might purchase $96 million of 5 1/2% notes; the $4 million difference between the SPE's assets (automobile receivables) and its liabilities (notes payable to institutions) provide note holders with some protection, as does the 1 1/2% interest rate spread between the 7% rate the pool earns on its auto receivables and the 5 1/2% it pays on its notes payable. The SPE would then pay most of the note it gave TF with the $96 million it received from institutional investors (Step 4). The $4 million difference would be TF's retained interest in the pool. The SPE first repays the $96 million notes to institutional investors, and pays servicing costs to collect the receivables. The remainder is paid to TF. If all of the auto purchasers repaid their principle and interest, there would be more than $4 million, because of the 1 1/2% interest rate difference (spread) and TF
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Session 26 - Securitization Accounting 2 (2) -...

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