Managing Rollover Risk with Capital Structure Covenants in Structured Finance Vehicles

Sanjiv Ranjan Das, Seoyoung Kim
2017 Journal of Fixed Income  
Managing Rollover Risk with Capital Structure Covenants in Structured Finance Vehicles 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
more » ... es 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. Our paper complements the work of Acharya, Gale, and Yorulmazer (2011) and He and Xiong (2012), who also explore the adversarial position across debt tranches in a continuoustime model. We extend the work of He and Xiong (2012) by providing a remedy to the adversarial problem that exacerbates rollover risk, and in contrast to Acharya, Gale, and Yorulmazer (2011), our model does not rely on information-theoretic arguments. Furthermore, we are especially interested in the capital structure of a structured finance vehicle in the presence of rollover risk. Thus, we also derive the maximal possible debt (i.e., equilibrium senior tranche size) of the SPV given senior note holders' risk preferences, while accounting
doi:10.3905/jfi.2017.26.4.092 fatcat:zgji76fjxzcgddz27uchxg2t34