The Design and Risk Management of Structured Finance Vehicles

Special purpose vehicles (SPVs), extremely popular financial structures for the creation of highly-rated tranched securities, experienced spectacular demise in the 2007-08 financial crisis. These financial vehicles epitomize the shadow banking sector, characterized by high leverage, undiversified asset pools, and long-dated assets supported by short-term debt, thus bearing material rollover risk on their liabilities which led to defeasance. This paper models these vehicles, and shows that imposing leverage risk control triggers can be optimal for all capital providers. The efficacy of these risk controls vary depending on anticipated asset volatility and fire-sale discounts on defeasance. Despite risk management controls, we show that a high failure rate is inherent in the design of these vehicles, and may be mitigated to some extent by including contingent capital provisions in the ex-ante covenants. Post the recent subprime financial crisis, we inform the creation of safer SPVs in structured finance, and propose avenues of mitigating risks faced by senior debt through deleveraging policies in the form of leverage risk controls and contingent capital