Capital Markets

Debt in Disguise

The boundaries between receivables securitizations and loans are blurring.
Vincent RyanNovember 1, 2007

Why does WESCO International Inc. use accounts-receivables securitization, a form of financing so closely linked to the subprime-mortgage meltdown? “Because we can,” says senior vice president and CFO Stephen Van Oss.

Van Oss is speaking only partly tongue-in-cheek. His company, a $5.3 billion distributor of electrical products, has a high-quality customer base and a robust IT platform for tracking the performance of receivables, capabilities demanded by banks and credit-rating agencies.

But securitization is also cheap. “It’s 60 to 80 basis points better pricing than any other asset-based program,” he says. “It’s the most efficient way to borrow money.”

Indeed, low cost is a key reason all forms of asset-backed securitization (ABS) have flourished (see “What Lies Beneath” at the end of this article), reaching $1.2 trillion in outstanding issues of asset-backed commercial paper last July. That’s up 83 percent in three years, according to the Securities Industry and Financial Markets Association (SIFMA). The “other” category of outstanding asset-backed securities, which includes corporate trade receivables, has also grown, to $993 billion as of second-quarter 2007. That $993 billion was more than the dollar amount of securities backed by credit-card receivables and home-equity loans combined, according to SIFMA.

The other advantage to ABS is that, unlike a loan, a corporation does not have to record it as debt. Securitization allows companies to transfer their trade receivables to a special-purpose entity, isolating them from the risks generally associated with the company. Accordingly, the SPE can raise money in the capital markets at a lower price than the company could directly because the SPE can garner a higher credit rating than the company as a whole (see “Anatomy of a Typical Securitization” at the end of this article).

In light of the crisis in subprime mortgages, however, securitization doesn’t seem as clever as it once did. “The subprime mess reminds the market that it matters what you securitize,” says Adrian Katz, CEO of Finacity, an asset-backed financing company. “A securitization is ultimately only as good as the ‘security’, the collateral.”

From a corporate perspective, another problem is that securitization vehicles may not be as safely off the balance sheet as they seem. The legal structure has not been battle-tested in the courts, lawyers admit. Employees may inadvertently cross invisible legal boundaries and invalidate these structures altogether. Some companies, WESCO among them, are putting them back on the balance sheet. That, in turn, reinforces the notion that receivables securitization is, in many ways, a secured bank loan in disguise — and a loan to a company that may be nowhere near investment-grade.

“What interests me is how this product got so big, when its legal underpinnings are arguably shaky,” says Ken Kettering, an associate professor at New York Law School.

Speculative-Grade Roots

To date, no one has claimed that trade-receivables securities are as flawed as those backed by subprime mortgages. Most securitization agreements come with representations and warranties that protect the cash flow, as well as credit enhancements like “overcollateralization,” the posting of more collateral than is needed to obtain financing.

In addition, “because the underlying assets have a short duration (30 to 45 days), trade receivables don’t pose the same price volatility [risk] as a 30-year mortgage,” says Katz. “The marked-to-market type calls don’t happen in trade receivables.”

Still, part of what backs the commercial paper bought as triple-A credits are receivables from companies that are junk or near-junk credits. For example, in 2003, with the help of Finacity, Sprint Canada secured a five-year deal to sell its receivables to National Bank of Canada’s commercial-paper conduit. Although the deal was A-rated, at the time Sprint Canada had senior secured notes deep in speculative-grade territory. Similarly, Finacity helped create a $55 million program last year for Alliance One International, a single-B leaf-tobacco merchant, many of whose customers operate in emerging markets.

Because the company that originates the receivables is still collecting the payments, servicing risk is a concern in these deals, Katz admits. Indeed, Finacity “buttresses” the servicing capabilities of its clients, he says, which tend to have less-robust systems than companies like WESCO. Finacity sets up the SPE, collects on the accounts, monitors the creditworthiness of debtors, and reports daily on receivables performance.

But even Katz says, “Receivables are very gritty and lots of things can happen — partial payments, delayed payments, totally disputed payments. A lot depends on the operational abilities of the seller.”

And on the judgment of the rating agencies. The purpose of securitization is to make the credit rating of the company practically irrelevant in a financing, so that even in a bankruptcy the receivables cash flow will be protected. The companies originating the securitization need the triple-A or near-triple-A stamp.

In addition to the rating of the originating company (if available), rating agencies examine the credit and collection policies of the company, as well as debtor concentration in the receivables pool and the performance record of receivables, says Ravi Gupta, a senior director in Fitch’s ABS group. Triggers that protect against dramatic declines in receivables performance — like those that set maximum limits for defaults, dilutions, and delinquencies — are also factored in.

But in reality, rating agencies rely more on risk mitigants such as liquidity lines from appropriately rated banks, and credit enhancements such as letters of credit. In a 2005 report, Fitch said that it “…places little or no reliance on the originator’s ability to meet its obligations if its [credit] rating is below that of the issued debt.”

The rating agencies also rely greatly on legal constructs that say the payment stream to investors will not be hindered. For instance, the transfer of receivables to the SPE must be a “true sale.” That is, the seller must not retain too much of the reward or the risk coming from the asset, says Robert Hahn, a partner with Hunton & Williams LLP. In addition, the SPE has to be “nonrecourse” — in other words, the company’s creditors must not have claim to the assets of the SPE if the originating company goes bankrupt.

“Securitization divorces the creditworthiness of the [company] from the credit of the pool,” says Mark Spradling, a partner with Vinson & Elkings LLP. “True sale and nonconsolidation are part of that separation.”

But the opinion that legal control of receivables has passed to a third party has not been litigated in the bankruptcy courts. When LTV Steel declared bankruptcy in 2000, it filed for access to securitized receivables, arguing that its securitizations were “disguised financings.” When a court agreed to hear LTV’s arguments, stunned lenders quickly arranged debtor-in-possession financing for the company — provided it dropped its claims to the receivables. As a result, the issue has never been resolved in the courts.

“There’s no bright-line test,” says Spradling.

Crossing a Fine Line

The delicate structure of securitizations is evident in the experiences of companies that have — sometimes accidentally — pierced the legal bubble on which this form of financing depends. Aspen Technology, a provider of process-optimization software, was forced to restate its financials going back to 2005 because it inadvertently violated the true-sale structure of its securitization. Salespeople at the company did so by licensing additional software to customers and consolidating the remaining balance of older installment receivables into the new contracts. The securitization agreement did not allow that in most cases. As a result, Aspen unintentionally regained control of some securitized receivables and was forced to alter its balance sheet.

It also is relatively easy for a company to cross the nonrecourse boundary on purpose. At $2.3 billion Volt Information Sciences, a staffing firm that has a $200 million securitization program, a customer with a large receivable whose debt was in the company’s securitized pool filed for bankruptcy last summer.

“Technically, it was not mine to do anything with,” says Volt senior vice president and treasurer Ludwig Guarino, speaking of the debt. But when a debt buyer was willing to pony up 90 cents on the dollar, Guarino got Mellon Bank N.A., sponsor of the commercial-paper conduit into which Volt sells its receivables, to give Guarino a release on the lien. “The cash goes into the SPE, just like any other cash collection,” Guarino says.

Not all banks would have allowed such an arrangement. A key question in true-sale opinions is, after all, “Is there recourse back to the seller on failure of performance of the asset? The more recourse there is back to the seller, the less it looks like a sale and the more it looks like a loan,” Spradling says. This, of course, was why many mortgage originators were reluctant to help struggling homeowners rework the terms of their loans this past summer.

In July, under pressure from Congress, the Securities and Exchange Commission gave subprime-mortgage lenders permission to modify already-securitized home loans — if a default seemed likely — without taking the assets back on their balance sheets. The impact that guidance might have on other securitizations simply was not discussed. But clearly, the ability of corporations to deal with debt that has been securitized is turning into more of a gray area.

Accounting Calls It Debt

Technically, according to Financial Accounting Standard No. 140, SPEs in securitizations qualify for off-balance-sheet treatment. But some corporations that securitize receivables, desiring to bring financial reporting in line with economic reality, are bringing them back on balance sheet and calling them debt. On-balance-sheet treatment, though, removes one of the prime advantages of securitization — raising capital without increasing the company’s leverage.

In December 2006, WESCO amended the accounting treatment of its $500 million securitization program by including receivables sold on its balance sheet and labeling them secured borrowings. The receivables showed up as short-term debt, instead of just appearing in a note to accounts receivable, and the costs of the securitization appeared on the interest expense line.

“We did it primarily for transparency and good governance. It has made it a lot easier for people to understand, and we don’t have to do reconciliation between GAAP and non-GAAP,” says Van Oss. “It had no impact on the economics.” The rating agencies did not downgrade the transaction nor did the commercial-paper conduit ask for more collateral to reflect the new treatment. Dean Foods, a $10 billion dairy-products maker, handles its securitization similarly, consolidating the assets of three SPEs. Volt does also.

“Professionals — debt analysts, bankers, and equity analysts — all add [receivables] securitizations back onto the balance sheet in figuring leverage and debt ratios,” says Bob Finley, managing director of Fifth Third Bank’s asset-securitization business. “It’s window dressing at best. Let’s just call it debt.”

Blowback from the era of Enron is one reason companies are tinkering with the accounting. More often than not, though, non-investment-grade companies still want to be able to handle securitizations off balance sheet, says Finacity’s Katz, adding that the companies that move securitization back on the balance sheet “are the companies that have the luxury of taking the high road.”

Too Big to Fail?

Securitization is definitely in the sights of banking regulators. In the wake of last summer’s credit-markets crisis, the International Monetary Fund warned banking regulators not to stifle the “enormous benefits” from financial innovation. But the IMF did call for a review of the different models by which banks pass on credit risk to investors. It also suggested that the rating agencies use different ratings for structured products and regular corporate debt.

If securitization were to go away or be drastically curtailed, says Van Oss, WESCO would just shift its debt to its slightly more expensive asset-based revolver.

But even securitization’s detractors admit it is probably here to stay. In the judgment of New York Law’s Kettering, this form of structured finance is too big to fail. If there were ever a ruling in the bankruptcy courts that nullified the structures of true sale and bankruptcy-remote SPEs, the rating agencies would have to downgrade all trade-receivables securitizations to the credit quality of the originators, he says.

“A court aware of the stakes is very unlikely to make such a ruling,” says Kettering, “and should that event occur, Congress would bail out the product.”

Vincent Ryan is a senior editor at CFO.

What Lies Beneath

Calculating the Cost of Securitization

Tapping the capital markets without a lending bank in between means that even non-investment-grade companies can finance at near what triple-A companies pay.

The “weighted average pool rate” that bank conduits charge to buy receivables is calculated on a daily basis and includes an agreed-upon margin on top of the rate the bank pays.

Short-term rates rose as high as 6 percent during last summer’s credit crunch, as bank conduits could not issue paper for longer than overnight, says William Rutkowski, a vice president in Wachovia Corp.’s conduit-securitization group. But after the Federal Reserve Board cut rates, banks issued paper with longer maturities, dropping commercial-paper rates to below 5 percent.

In the past year, the cost of funds for securitization programs has started at 5.3 percent. However, in some securitization agreements, if the conduit cannot move its commercial paper, the rate passed through to the originator climbs to the prime rate or even LIBOR plus a set spread. If a portion of the receivables securitization facility is unused, the originating company may also have to pay a program fee on that unused amount ranging from 100 to 400 basis points.

CFOs also have to consider the costs of credit enhancement as well as those for the services of lawyers and investment bankers. For example, to ensure investors will not suffer losses from delayed collections or defaults, the originator must sell to the special-purpose entity a level of receivables in excess of the amount needed to pay for the securities issued. In most cases, “true-sale” treatment requires that any residual value from this “overcollateralization” not be available to the originator.

For some companies, information-systems costs could be the highest hurdle. Without an upgrade, a company’s current systems may not be able to handle the ongoing and historical analysis of delinquency statistics, dilution figures, and breakdowns of customer concentrations that rating agencies and bank conduits demand. — V.R.