Application of proceeds
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The Law and Lore of Repackaging
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There comes a time in a asset-backed espievie’s life when things go Germknödel in der Luft. This can happen two ways:
The expected way: because some part of the security package — an underlying asset, a swap counterparty or, heaven forbid, the paying agent has failed. These are regrettable externalities of la vie financière which no-one wants, exactly, but exposure to these risks, and the compensation one earns for running them, is what motivates repackaging investors to come to the table in the first place: if none of these risks ever came about there would no risk premium either.
The unexpected way: because the espievie itself has failed. This is unexpected because from its socks and bloomers a repackaging vehicle is architected so that it cannot, even in theory, go bankrupt. but espievies can go bankrupt, in practice — at least in theory. If you see what I mean. But it involves — whisper it — someone screwing up. For an SPV to go insolvent there much be a flaw of some kind in the ring-fencing.
Depending on which way your espievie has gone seins en l’air, there is a different method to unwinding the deal. Both involve liquidating everything; one (the expected way) takes place in the ordinary course and is carried out without fuss, by agents (disposal agents, calculation agents, collateral managers etc) appointed by the SPV for that exact purpose; the other (the unexpected way) takes place under the auspices of the Law of Property Act 1925, and involves the Trustee appointing a receiver and all kinds of fear and loathing. For more on this, see enforcing security.
In either case you need some provisions to guide whoever is wielding the chainsaw on how to divvy up the SPV’s resources one they have been terminated with extreme prejudice. This is the application of proceeds clause.
Payments waterfall
The order in which the proceeds must be applied is usually set out as a list of secured creditors, in order. You pay the guy at the top, then — if anything is left — the next guy, and so on. In one of those witty visual metaphors of which lawyers are so fond, this is called a “payments waterfall”.
There are a lot of secured parties, but most of them (the trustee and the agents) aren’t likely to be owed very much, and in the time-honoured tradition of all agency arrangements, these guys get paid first. The real action is generally between the hedge counterparty and the noteholders, especially where there is a counterparty “flip clause”. In any case there is a whole lot more at the payments waterfall page.
Pre-enforcement and post-enforcement
As well as the “flip clause” it is time-honoured to set out two payments waterfalls: pre-enforcement and post-enforcement. These will both usually be set out in full, in the grandiloquent prose of the capital markets, even though the practical difference between them is — well, nil, as you are invited to see for yourself with this comparison of the terms in the inimitable SPIRE programme (don’t click on that link, honestly, it doesn’t matter how bored you are you are not that bored).
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