Under Basel 2, the specialized lending activities are differentiated because they have dedicated capital treatment, due to the specific economics of these transactions. Essentially, specialized lending has a credit risk that could be qualified as primarily "transaction-based" and "collateral-based." The five sub-classes of specialized lending are: project finance, object finance, commodities finance, income-producing real estate, and high-volatility commercial real estate.

In specialized lending, the transaction risk is more isolated from the credit standing of the borrower(s) since the actual borrower is a dedicated vehicle which secures the debt with the cash flows generated by its assets. The direct counterparty for lending is a "special purpose entity," or "SPE," which shelters the "object" financed that secures the transaction, and is isolated from the borrower. According to Basel 2, the common features to all specialized lending (SL) transactions are as follows:

§219. The exposure is typically to an entity, often a special purpose entity (SPE) which was created specifically to finance and/or operate physical assets;

The borrowing entity has little or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;

The terms of the obligation give the lender a substantial degree of control over the asset(s) and the income that it generates;

As a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.

Basel 2 describes the salient features of SPEs as follows:

§552. An SPE is a corporation, trust, or other entity organized for a specific purpose, the activities of which are limited to those appropriate to accomplish the purpose of the SPE, and the structure of which is intended to isolate the SPE from the credit risk of an originator or seller of exposures.

SPEs are commonly used as financing vehicles in which exposures are sold to a trust or similar entity in exchange for cash or other assets funded by debt issued by the trust.

The subsequent descriptions of the five different specialized lending transactions detail the specific features of each sub-class. In many cases, we replicate below the Basel 2 definitions, which are both precise and self-explanatory.

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