What is an Esoteric Debt?
An esoteric debt is a complex investment vehicle that is offered to a unique group of investors, as they are difficult to value because of their distinctive pricing and structure. The best example that can be given is that of a credit default swap derivative that resulted in the 2008 Global Financial Crisis in the U.S.
- An esoteric debt security is a complex investment vehicle usually purchased by institutional investors – like mutual or hedge funds – where debt is pooled together to form a security and is sold to investors in return for fixed or variable payments received from the money paid by borrowers of the debt.
- The process of pooling together assets is called securitization. The originator of the loan – or the lender – usually decides which asset classes are to be pooled to form the security.
- The special purpose vehicle is formed by the originator as a separate legal entity that is protected by the originator’s financial risk and are the holders of the securities.
Asset-backed securities, or ABS, are common types of esoteric debt instruments where loans are pooled together and sold to the public as security. The process of pooling the loans or other types of securities is called securitization. The loans that are securitized include residential loans (mortgages), commercial mortgages, car loans, student loans, and credit cards.
How Do Esoteric Debt Securities Work?
When an individual borrows money from a lender, it is an asset for the lender in their books. The lender then sells these assets to a special purpose vehicle (SPV), which pools them together to form asset-backed securities. The securities are sold to the general public in the secondary market. The principal repayment and interest payments made by the borrowers of the loan are passed to the investors of the asset-backed securities.
The originator (lender of the loan) is the institution that creates the pooled assets. They are the ones who decide the debt (commercial mortgages) to be pooled. Once the decision is made, the pooled assets are then sold to an issuer.
The issuer is usually a special purpose vehicle (SPV) or a special purpose entity (SPE), which is a subsidiary created by the parent company to isolate itself from the financial risk faced by the parent company.
Benefits of Esoteric Debt Securities
The benefit to the issuer of the esoteric debt security is that the debt is eliminated from the books of the issuer. It gives them access to new funds and also allows them to focus their attention on identifying new business opportunities. The owner of the security can diversify their portfolio and get better yield relative to a government bond.
Risks Associated With Esoteric Debt Securities
1. Counterparty Risk
A servicer is an important stakeholder in esoteric debt securities. They are responsible for collecting the principal and interest payments from the loan, distributing them to the owners of the securities, and handling any defaults. The servicer’s failure to perform its duties can weaken the whole structure of the esoteric securities.
2. Prepayment Risk
Prepayment is a situation where the borrower prepays the loan to refinance it at a lower interest rate from another lender. It can be a risk to the owner of the esoteric debt security, as there will be no collections, as a result of the prepayment of the loan.
3. Market Risk
There are two types of market risk – cross-currency risk and interest rate risk.
- Cross-currency risk occurs when there are assets with one or more currencies that may be different from the currency of the loan.
- Interest rate risk is the variance between the fixed-interest collections from the loan and the floating interest rate paid to the owners of the securities or vice versa.
4. Credit Risk
The type of debt backed to security is important in measuring the credit quality of the esoteric security. Credit risk occurs when there is a default in interest and principal payment of the loan that has been securitized. This could impact the cash flow to the owners of esoteric security.
5. Legal Risk
The transfer of assets from the originator to the issuer must be such that an originator’s insolvency or bankruptcy does not impair the issuer’s control over the assets and the cash flows generated by the pooled securities. There can be a legal risk if the relevant bankruptcy and corporate laws of a particular jurisdiction are weak.
The securitization process involves the following steps:
- The lender (originator) provides loans to borrowers who, in turn, provide interest payment and principal repayment in the form of receivables to the originator.
- The originator then sets up a special purpose vehicle, where the loans are pooled to form esoteric debt securities. The SPV is a separate legal entity that is protected from the financial risk of the parent company.
- The originator then sells the receivables to the SPV, who in turn, provides the securities to the investor (owner).
- The investor buys the securities from the SPV in return for the securities.
- The SPV then provides the cash to the originator of the loan. Since the process is risky, the credit rating agencies play an important role by rating the securities.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: