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I was reading a book explaining Special Purpose Entities (SPEs) and an example is used in the book:

a firm could sell loans it has made to customers to an SPE that issues bonds to purchase the loans. The interest and principal payments on the loans are then used to make the interest and principal payments on the bonds


I wonder what might be the reasons for a corporation to decide to establish an SPE and to further engage in investment as mentioned above. Specifically, why would the SPE want to purchase another company's loan by borrowing money via bond issuing?

The book doesn't further explain the motivation behind such behavior. My current thought is maybe the parent company of the SPE wants to make a profit by investing in undervalued loans (the loan is considered by the seller to default but SPE doesn't agree with such expectation) while maintaining a relatively low financing cost (maybe SPE has a low financing cost due to its parent's strong-rating or maybe due to a sudden plunge of yield in bond market).

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why would the SPE want to purchase another company's loan by borrowing money via bond issuing?

Your question is worded in such a way that makes it sound like the SPE is already established and makes a choice to buy the loan from other companies, which is usually not the case. More common is a bank or other entity creates an SPE with the specific purpose to sell its loans to it, and the SPE raises the money to buy the loans by selling bonds to investors, who get relatively stable cash flows from the bonds, which are funded by the loan payments. So it's not necessarily to make a profit from "undervalued" loans, but more to monetize the loans without having to sell them outright.

Some reasons for creating an SPE:

  • To separate the credit rating of the SPE from the credit of the creating entity (e.g. bank).
    • The SPE is rated based on the loans it holds, not on the operating risk of the creating company.
  • To protect both entities from financial distress of the other
    • If the bank goes bankrupt, the SPE can survive, and vice-versa
  • Monetization
    • A company can sell portions of the SPE to other investors without having to dilute ownership in the company
  • Spread risk
    • A company can sell interest in the SPE to reduce the overall risk

There may be other, more nefarious reasons, such as to hide liabilities like Enron did or to avoid taxes.

  • But why can't the creating entity monetize the loans itself by selling them outright? If it's a bad loan, the originating entity can still sell it outright to reduce its own risk of holding bad loans? – Nicholas May 8 '18 at 19:15
  • It probably can but that's not what it's created for. It's generally more profitable to monetize loans through an SPE that by selling them outright (there's not a huge secondary market for bank loans). The originating entity can transfer the risk of a bad loan to the SPE by selling it the loan. – D Stanley May 8 '18 at 19:25
  • Okay, I should've asked why "it's generally more profitable to monetize loans through an SPE". To me, saying "the originating entity can transfer the risk of a bad loan to the SPE" is like saying "the originating entity can transfer the risk of a bad loan to any potential investor in the market" – Nicholas May 8 '18 at 19:32
  • Because there's not a huge market for bank loans, the prices generally aren't favorable to the banks (it's a "buyer's market"), and it's not easy for banks to sell loans directly. The banks can generally get a better return from the bonds sold by the SPE with less effort. – D Stanley May 8 '18 at 19:40

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