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Corporate insolvencies are testing whether securitization is a stable structure or a flimsy facade.
Tim Reason, CFO Magazine
June 1, 2003
At the Bond Market Association's annual meeting in New York in April, the moderator of a panel on asset-backed securitization (ABS) joked that this enormously popular form of structured financing has "proven to be bankruptcy remote — except perhaps in the event of bankruptcy."
For CFOs, that's no joke. ABS is popular precisely because transferring illiquid corporate assets (such as receivables) to a bankruptcy-remote entity allows them to be repackaged and sold as securities. Once the underlying assets are legally separated from the company's fortunes — and its creditors — those securities typically carry higher ratings than the company's own debt issues.
Back in 1999, the asset-backed commercial-paper (ABCP) market — in which corporate trade receivables are the dominant asset class — held $517 billion in assets. But use of ABS has soared since then. Because it effectively gives them access to the lower interest rates of the AAA debt markets, many companies find securitization to be an inexpensive alternative to revolvers or other forms of direct financing. The fact that these transactions are off-balance-sheet and the proceeds can be reported in financial statements as cash from operations, rather than financing, only adds to their popularity. The day that joke was delivered at the Bond Market Association (BMA) meeting, the ABCP market held $708 billion in assets.
To most observers, the biggest threat to this booming industry is a new accounting rule that goes into effect next month requiring companies and their banks to bring these bankruptcy-remote vehicles back onto their balance sheets (see "FASB: A Four-Letter Word?" at the end of this article). That has caused a lot of pain — the asset-backed commercial paper market has dropped from its peak of $745 billion since standard setters first began debating the change — and it is certain to raise costs for banks that sponsor the conduits through which ABCP and other securities are sold.
But the greater threat to ABS may be its own success in giving companies — including financially troubled ones — access to capital during tough times. Although the number of public-company bankruptcies fell to 191 from 2001's all-time high of 257, large-company bankruptcies are on the rise. As more of these companies file for Chapter 11, legal challenges to the very structure of securitization are likely to increase. "With the uptick in ABS and more big companies going into bankruptcy, it wouldn't surprise me if some of these [facilities] get tested in court," observes Mark Scoles, a partner with Chicago-based Grant Thornton. "There's an awful lot at stake for creditors if they can pierce these [structures] and bring the assets back into the company."
A Troubling Case
In legal terms, securitization is not viewed (as its name might seem to imply) as a secured financing. Instead, it is considered a "true sale" of the receivables or other corporate assets to a special-purpose entity (SPE). In most cases, companies continue to collect their own receivables, but the idea that legal control of those funds has passed to a third party is essential to the securitization structure. Auditors require a true-sale opinion from an attorney before approving off-balance-sheet treatment of a securitization, and credit rating agencies require the same before they will rate the resulting securities.
To date, this has generally worked. In fact, a trade-receivables securitization went unchallenged in the case of WorldCom, the largest bankruptcy in history. Yet the past decade has seen increasingly frequent attacks on securitization. Although rarely reported in the business press, these attacks have often sent shudders through the industry. Companies whose bankruptcies resulted in challenges to their securitizations or huge losses to investors in the securities include National Century, NAL Financial Group, Heilig-Meyers, LTV Steel, NextCard, Contimortgage, Conseco, Commercial Financial Services, and, of course, Enron.
Most prominent among these was the case of LTV Steel. On December 29, 2000, LTV declared bankruptcy and simultaneously filed an emergency motion asking for access to receivables and inventory that had long been securitized by a consortium of banks. The transactions, argued LTV, were not true sales but "disguised financings." To the collective horror of the banks, the judge allowed LTV interim access to the cash and scheduled a hearing to discuss the merits of LTV's argument. The structured-finance industry predicted dire economic consequences if LTV were to prevail.
Alarmed, Abbey National and the other banks quickly drew up debtor-in-possession (DIP) financing that was contingent on the company's agreeing that the securitization had in fact been a true sale. That averted the crisis, but didn't resolve the issue. Asked recently by CFO whether the true-sale question still posed a challenge to securitization, Tina Brozman, former chief judge of the U.S. Bankruptcy Court for the Southern District of New York, said, "It hasn't been resolved to my knowledge."
To date, however, cases such as LTV generally have been dismissed as aberrations by the securitization industry. Last year, Standard & Poor's insisted that attorneys submitting true-sale opinions to the rating agency stop referring to LTV, noting that the court never made a final decision and that such citations inappropriately cast doubt on the opinion. Seven months later, in a delicately worded press release, S&P withdrew that prohibition — apparently because lawyers refused to ignore such an obvious legal land mine.
Kenneth Kettering, associate professor at New York Law School, argues that the securitization industry owes its very existence to the willingness of rating agencies to rate ABS securities based on "extravagantly hedged" true-sale opinions. "No competent lawyer ever gave a simple flat opinion that the asset transfers involved in a securitization transaction constitute a 'true sale.' Indeed, given the absence of controlling case law, a lawyer could not responsibly do so," he wrote in a letter to Congress. "These all-but-liability-proof legal opinions underline the fact that the parties to a securitization transaction are knowingly assuming a serious legal risk."
Legislating the Answer
One obvious remedy would be to eliminate that risk through legislation. That was tried last year in an amendment to bankruptcy legislation that would have defined securitization as a true sale, effectively giving it safe harbor from bankruptcy.
The problem with that is that bankruptcy courts would be automatically prohibited from reviewing securitizations that followed certain guidelines. Kettering and 34 other law professors objected on those grounds. The amendment, they told Congress, "permits a debtor and one favored creditor to engage in a secret transaction to remove valuable, liquid assets from the corporate bankruptcy estate of a troubled borrower and place them beyond the reach of the courts and other creditors."
The BMA, which supported the measure, shot back that the amendment would reduce uncertainty, which in turn would reduce costs. It further contended that efficient securitization is a boon to the economy. "Companies that use securitization have been able to significantly reduce their cost of funds, increase liquidity, and obtain greater and more-diversified access to the capital markets," wrote BMA executive vice president John Vogt, adding that the amendment would eliminate "an undesirable degree of residual uncertainty...which raises the overall cost and expense of funding securitized assets."
That argument, scoffs Kettering, is disingenuous, because the industry knowingly took on that risk in the first place. "It is no different than the person who kills his parents and then pleads for mercy on the grounds that he's an orphan," he argues. It's something of a pattern, he adds, for the financial industry to create legally shaky but profitable financial products, and then demand legislative or judicial relief from the legal risks once use of a product is widespread.
At this point, the amendment is off the table — it was stripped from both House and Senate bills, which themselves were later killed. But the amendment was only the latest incarnation of safe-harbor legislation. "I would not be surprised to see it resurrected," says Kettering. "This is going to be a permanent issue."
In the absence of such legislation, challenges to true sale in court continue to be likely — even if the goal is simply to extract other concessions. "Bankruptcy is all about negotiating," says Brozman. "Many times claims are brought simply to gain leverage." If nothing else, the rapid assembly of DIP financing in the LTV case is proof that these challenges are effective.
Such bargaining strategies put the future of ABS in the hands of judges. "I think courts are anxious to preserve the securitization market and doctrine," said James Tancredi, an attorney with Hartford-based Day, Berry & Howard, speaking at the BMA panel. "But they are often driven by distress in troubled businesses to test those doctrines."
The true-sale issue has resurfaced recently — not surprisingly, among the many battles in Enron's sprawling bankruptcy proceedings. The energy company's widespread abuse of securitization structures drove almost all of the current accounting changes affecting securitization, but in this case, it also is generating legal challenges reminiscent of LTV. Enron made use of financial asset securitization investment trusts, or FASITs, a rarely used type of securitization conduit whose primary benefit for Enron appears to have been tax avoidance. As with LTV, however, banks have been forced to fight to keep Enron receivables sold to the FASIT out of the bankruptcy estate.
True sale is not the only potential legal challenge to securitization. Kettering goes so far as to argue that securitization could be challenged under so-called fraudulent conveyance laws. Bankers and structured-finance professionals, not surprisingly, bridle at suggestions of fraud. But, explains Kettering, the legal definition of fraudulent conveyance goes beyond fraud, and includes any transfer of assets intended to hinder or delay creditors' access to those assets. "And aren't securitizations designed to do just that?" he asks.
Even if bankruptcy courts don't buy the argument that a securitization is fraudulent, they can simply impose a "substantive consolidation" on a company and its SPE — essentially overruling the idea that there is any division between them (or their assets). To date, this is rare, although new rules that require consolidation from an accounting perspective may provide creditors with added ammunition in arguing for such a step in the legal realm. Accounting and law are different worlds, says Grant Thornton's Scoles, "but this is an area where they very much come together."
Breaching the Contract
Moreover, bankruptcy courts are courts of equity — unfriendly places for carefully erected financial structures like securitization. Bankruptcy judges have great freedom to interpret the law as they see fit. "Quite frankly, bankruptcy is like Alice in Wonderland," said Tancredi. "It is an elastic process, and notions of fundamental contract law are often out the door. To stand behind your black-and-white legal rights [in bankruptcy court] is sometimes a losing battle."
Even if the legal structure of securitization isn't directly assaulted, bankruptcies can often wreak havoc with the terms of a securitization. One problematic area is the servicing contract that requires the company to collect receivables.
Take, for example, what happened at Conseco, whose Green Tree subsidiary had securitized pools of manufactured-housing loans. As in most securitizations, Conseco acted as the servicer. But the servicing fees it charged were low and, in the event of bankruptcy, could not be collected until other creditors were paid. After its bankruptcy, Conseco threatened to walk away from the servicing unless the fees were raised substantially and paid ahead of other claims. That, of course, would have significantly reduced payments to investors. To mitigate potentially huge losses on the Conseco transaction (the total securitization represented more than $23 billion in bonds), large institutional investors such as TIAA-CREF and Fannie Mae were forced to band together in court to protect their remaining interests in the deteriorating securities.
Conseco's securitization also was worrisome because the company didn't off-load the credit risk, bringing it back on balance sheet instead by guaranteeing the lowest tranche of the securitization. This effectively created a corporate credit obligation where none was supposed to exist — the same sort of problem that triggered Enron's downfall.
Moreover, bankruptcy can change the very nature of the assets underlying the securitization. Investors in credit-card receivables securitized by NextCard got burned when the bank was put into receivership by the Federal Deposit Insurance Corp. Unable to find a buyer for the bank' s credit-card portfolio, the FDIC shut it down. That turned the assets from a revolving pool to an amortizing one and, again, resulted in losses to bondholders. "If a credit-card deal [amortizes] early, [investors] get clipped pretty good," notes Mark Stancher, a vice president at JP Morgan Fleming Asset Management.
The elasticity of bankruptcy proceedings illustrates the fragility of the rating process when it comes to asset-backed securities. "The documents in the Conseco case went out the window, and those are one of the key things we base the rating on," said BMA panelist Jay Eisbruck of Moody's. "If we can't rely on what's written in the documents, we need to modify the way we approach rating transactions."
The fact that both the market and rating agencies are increasingly uncertain about the stability of asset-backed securities calls into question one of the most commonly cited market benefits of securitization — that is, that it converts illiquid assets into the sorts of safe, highly rated investment vehicles investors crave.
Both attorneys on the panel argued that the problems with Conseco, Next-Card, and similar blowups resulted from deals that were poorly structured and had underpriced servicing fees. Translation: a carefully structured securitization can survive bankruptcy, say lawyers, but not if it's done on the cheap.
Moderator Christopher Flanagan (who opened with the joke about securitization in bankruptcy), managing director of global structured finance research for JP Morgan Securities Inc., also asked Moody's Eisbruck if single-B-rated companies should have the ability to issue AAA debt. "The answer is still yes," Eisbruck replied, "but I would say it should require a lot more credit enhancement."
Securitization may yet be saved by legislation or destroyed by an adverse court ruling. In the meantime, that uncertainty is sure to have one result at least: the cost of this type of credit is going up.
Is FASB a Four-Letter Word?
Bankruptcy decisions may sporadically rock the securitization world, but lately, structured-finance professionals worry more about the decisions coming out of the Financial Accounting Standards Board.
Starting July 1, under FASB's Financial Interpretation 46, company and bank financial statements will have to detail — and, in most cases, consolidate — the existing off-balance-sheet special-purpose entities, or SPEs (now known as variable-interest entities), used for securitization. The resulting frustration and anger in the industry was evident in the responses — some of them expletive-laced — to a March survey of reaction to FIN 46 by Standard & Poor's.
"[FIN 46] was rushed to the market with inadequate guidance for implementation," complained one respondent. "The rule makes the asset class more risky in the long run."
More than half of the respondents predicted companies would now choose other debt instruments over asset-backed commercial paper (ABCP), and almost a third said many companies would shut down existing securitization facilities rather than disclose them. Bottom line: More than 72 percent of survey participants believe that the broadened disclosure requirements would result in increased cost to banks, because the requirements would force them to restructure existing conduits used to issue ABCP and collateralized debt obligations in order to avoid consolidation.
But that may not even be possible. At an April meeting of the Bond Market Association, FASB's chairman, Robert Herz, told CFO that the board plans to more clearly define "qualified SPEs" — passive investment vehicles used in securitization that are traditionally excluded from consolidation requirements. "We gave [QSPEs] temporary diplomatic immunity," Herz later warned the audience. "Now we are going to make sure they are qualified diplomats." In response to testy questions from the audience, he added that while FASB was not blind to the market impact of FIN 46, the board's overriding concern was financial-statement transparency.
That concern could affect more than the balance sheet. Herz afterward told CFO that the accounting treatment that allows asset-backed securitization proceeds to appear as cash flow from operations rather than financing is already under review as part of FASB's financial performance reporting project.
Eve of Destruction?
In 1993, rating agencies began downgrading securities backed by receivables from companies in Colorado, Kansas, New Mexico, Oklahoma, Utah, and Wyoming — all states under the jurisdiction of the 10th Circuit Court, which had just ruled in the bankruptcy of Octagon Gas that receivables remain part of a debtor's estate, even if sold.
By all accounts, Octagon was a bad decision, based on the judge's misreading of the Uniform Commercial Code, which itself was later amended. And given the traditional flexibility of bankruptcy venues, the rating agencies' decision to punish companies in particular states was equally bizarre.
Nonetheless, when LTV Steel asked the U.S. Bankruptcy Court of the Northern District of Ohio to overturn its securitization in December 2000, companies and banks with asset-backed securitization facilities or services, along with the Bond Market Association, quickly filed a friend-of-the-court brief invoking Octagon and warning of similar credit woes for companies in that district if the court ruled in LTV's favor. Such a ruling "could have dire consequences for the entire market nationwide," the brief warned.
"In the end, a victory for LTV is likely to inflict a serious blow on a broad segment of the economy as manufacturers, retailers, and finance companies find it more difficult to finance their operations at a reasonable cost," the brief predicted. "Some companies might find themselves unable to obtain financing at all and might be forced to curtail their operations or even to declare bankruptcy. Jobs would be lost. Investors would be injured. Consumers would find it more difficult to obtain credit."
In the end, of course, nothing of the sort happened. But the question lingers: Was this plaintive warning from the structured-finance community a bit of legal hyperbole designed to sway a judge, or an accurate depiction of the degree to which the economy depends on a legally shaky product?