Designed for Failure? Risk-Return Tradeoff s and Risk Management of Structured Investment Vehicles

Abstract

The Design of Structured Finance Vehicles We model the design of a structured finance deal, specifically, its capital structure, leverage risk controls, asset quality, and the rollover frequency of senior debt. Instead of providing safety, stringent risk management controls often accelerate failure, and optimal risk management choices depend critically on the rollover horizon of the senior notes. The expected losses on senior notes become increasingly sensitive to pool risk (i.e., spread volatility) when risk controls become more stringent, particularly under shorter rollover horizons. Post the financial crisis, we intend to inform the creation of safer SPVs in structured finance, and we propose avenues of mitigating senior note risk through contingent capital.