Managing Rollover Risk with Capital Structure Covenants in Structured Finance Vehicles
45 Pages Posted: 28 Dec 2015 Last revised: 9 Mar 2017
Date Written: March 7, 2017
The shadow banking system comprises special purpose vehicles (SPVs) characterized by high debt, illiquid long-maturity assets funded predominantly by short-maturity debt, and tranched liabilities also known as the capital structure of the SPV. These three features lead to an adversarial game among senior-note holders, who solve for an optimal rollover policy based on the other senior tranches with varying rollover dates. This rollover policy is, in turn, taken into account by capital-note holders (i.e., investors in the equity tranche) when choosing the capital structure (i.e., the assets-to-debt ratio) of the SPV. Rollover risk increases in the number of time tranches, resulting in a lower equilibrium level of debt and higher cost of debt. The expected life of the SPV may also be shortened. We propose a covenant-based capital structure that mitigates these problems and is Pareto-improving for equity and debt holders in the SPV.
Keywords: special purpose vehicle, structured finance, rollover risk, leverage, capital structure, covenants
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