What the credit analyst should know about securitization.
This is an important topic for credit managers since the securitization of assets can have an important impact on the creditworthiness of the parties involved. Furthermore, the volume of such transactions continues to explode. Standard & Poor's estimates that just one portion of the market - asset-backed commercial paper - involved more than $75 billion outstanding debt in 1995. The volume is certainly larger today.
How Securitization Is Accomplished. The development of the securitization market is generally traced from the mortgage-backed securities first sold in the 1970s, although some of the concepts, such as single purpose borrowers, have long been used in a variety of financing transactions. Rather than raising funds to make mortgage loans only through deposits, mortgage lenders sell off groups of mortgages to a trust that raises the purchase money in the securities market. The sale provides the lender with new funds to make additional loans. The lender or an affiliate continues to generate fee income from originating and "servicing" the loans that are sold by collecting the mortgage payments and passing them along to the investors and where necessary, pursuing defaulting borrowers. The mortgages are no longer assets of the lender and no longer appear on the lender's balance sheet.
Investors purchasing mortgage-backed securities buy the right to receive the payments made by the borrowers as they are made. They generally have no claim against the lender to recover their investment, but conversely have no risk that the payments from the borrowers will be interrupted or diverted in the event of an insolvency of the lender. A wide variety of assets, now including auto loans, credit card receivables, and equipment leases have become subject to securitization transactions. New types of transactions are constantly being created.
The parties to a securitization transaction include:
Originator - the business that originally owns or generates the assets that are the subject of the transaction
Special Purpose Vehicle (SPV) - the new entity to which the assets are to be transferred. The SPV may be a trust, a partnership, a corporation or almost any other form of business organization.
Servicer - the company, frequently the Originator or an affiliate, that collects the cash flow from the assets to pay the return on the securities created in the transaction.
The simplest structure requires no more. More complex structures may add:
Liquidity provider - a financial institution that will make short term loans to ensure the regular flow of payments necessary for a favorable rating on the securities.
Credit Enhancer - a bank that issues a letter of credit or a financial guaranty insurance company that issues an insurance policy covering payment to the investors.
Rating Agency - a recognized credit evaluator, such as Standard & Poor's and Moody's, that publishes ratings of the credit risk of the securities issued. A rating enhances the marketability of the securities.
Conduits - investment pools that purchase only asset-backed securities issued by SPV's whose securities meet specified criteria. Conduits, like any pooled investment vehicle, permit an investor to spread risk by effectively buying securities from a group of SPV's. On the other side, conduits expand the SPV's sources of funds.
The goal of a securitization is to obtain a rating for the securities issued by the SPV that is higher than the rating for the obligations of the Originator. The higher rating means a reduced interest rate.
Standard & Poor's and Moody's have established criteria for the structure and other terms of securitization transactions in order to obtain favorable ratings. Those agencies and others rate scores of transactions annually involving billions of dollars of assets:
Elements of a Securitization Transaction. The first element of securitization transaction is the transfer of the assets from the originator to the SPV. This may be structured as a sale in exchange for the cash proceeds of the sale of the securities, a contribution to the capital of the SPV, a loan to the SPV, or some combination of these elements. Any debt claims of the Originator against the SPV will be subordinated to the securities sold to the outside investors.
The next element is the sale of securities. The SPV raises the funds to acquire the assets from the Originator by the sale of securities to investors. The securities may be debt obligations of the SPV requiring payments of scheduled installments of principal and interest or "pass-through" obligations in which the SPV's only obligation is to remit to the investors the cash flow generated by the assets. Typically, there are several tiers of securities issued with different priorities of claims against the cash flow. The subordination of the junior securities is an additional form of credit enhancement of the senior securities. The securities are not direct obligations of the Originator although the Originator may provide warranties concerning the quality of the assets and collectability of the cash flow or, in some cases, a guarantee of some of the obligations.
The final element is the execution of the Servicing Agreement. The Servicer enters into a contract to collect the cash flow from the assets and remit the balance, after its servicing fee, to the investors.
Legal Considerations for Credit Evaluations. The basis of making a credit evaluation of the securities of the SPV independent of the creditworthiness of the Originator is that the assets which have been securitized are effectively removed from the Originator. In legal parlance, the issues are framed in terms of determining that the transfer of the assets to the SPV is a true sale and that the SPV is bankruptcy remote. Legal opinions from counsel for the Originator and SPV provide comfort on these issues.
True sale means that the validity of the transfer of the securitized assets from the Originator to the SPV will be respected in a bankruptcy of the Originator. Investors require assurance that the transaction will not be treated as merely a loan by the SPV to the Originator. If it is, the consent of the bankruptcy court would be required to continue to collect the cash flow generated by the assets after a bankruptcy of the Originator. If the necessary steps have not been taken to perfect the transfer of the assets to the SPV, the security holders could be treated as general unsecured creditors of the Originator. Bankruptcy remoteness has two facets. First, the SPV must be shielded from the consequences of a bankruptcy of the Originator. This is accomplished largely by means of assuring that the assets have been effectively transferred to the SPV (the true sale discussed above) and that the separateness of the SPV will be respected.
The separate status of affiliated corporations is sometimes ignored and their assets and liabilities are treated together as one entity under the bankruptcy doctrine of substantive consideration. The basis of substantive consolidation is similar to "piercing the corporate veil" of limited liability where a shareholder is held liable for the debts of a corporation because of the failure to follow necessary corporate formalities or injury to creditors who were mislead in believing that several corporations were one.
To avoid consolidation, separateness covenants are included in the SPV's organizational documents and in the servicing agreement requiring that the SPV have independent operations.
The second facet of bankruptcy remoteness is that the SPV itself be unlikely to become financially distressed. That is accomplished by limiting the activities of the SPV to the financing that is the subject of the securitization and by seeking agreements from all parties that deal with the SPV, including the parties to the securitization financing, that they will not initiate a bankruptcy case against the SPV.
In addition, steps are taken to prevent the Originator from causing the SPV to commence a voluntary bankruptcy case. This is accomplished, in the case of a corporation, by requiring the appointment to the board of directors of an independent director charged with fiduciary duties to the creditors. The independent director's consent is required to initiate a bankruptcy case and is expected to be withheld if the only benefit of the bankruptcy filing is to assist the Originator. The consent of the parties to the financing is required to any amendments to the corporate governance documents of the SPV. Similar protections are incorporated into the governance of trusts, partnerships or other entities which may be used as the SPV.
Impact of Securitization on Credit Analysis. Credit managers should understand that a securitization transaction removes the securitized assets from those available to satisfy the general creditors of the originator. The assets are transferred to a separate company. In some structures the SPV may be an orphan sub that is not owned by the Originator. Consequently, its assets do not appear in the Originator's financial statements. In the Sea Containers transaction and others, the SPV is a consolidated subsidiary of the Originator. Its assets and the accompanying debt will appear in consolidated financial statements with footnote disclosure that the assets are in a subsidiary and subject to the liens of the parties who purchased the securitized debt.
The securitization market continues to expand both in volume and in the development of new structures. It has become a new source of capital for an expanding array of companies. Today's credit analyst must understand how securitization works in order to properly evaluate the credit of the parties raising capital in this market.
Case Example: Securitization of Marine Cargo Containers
In a recent transaction, Sea Containers Ltd., the multi-billion dollar international company involved in leisure, ferry operation and equipment leasing businesses securitized approximately one-third of its $750 million portfolio of marine cargo container equipment. Marine cargo containers are the basic units of modern intermodal transportation.
Developed after World War II, a basic shipping container is a truck trailer without wheels that can be loaded with cargo at the shipper's premise and then transported to the customer by truck, rail and ship without repacking the goods. The container is moved by crane or forklift to and from a truck bed trailer, a railroad flatcar or a ship compartment. In addition to basic "dry box" containers, there are refrigerated containers, tank containers, bags and "flat racks" on which a wide variety of cargo may be carried.
The capital equipment cost of a single container may exceed $20,000. Sea Containers Ltd. is a leading participant in the container leasing industry that grew up to supply equipment to ocean shipping lines and other customers who do not wish to or are unable to purchase all of the equipment to meet their needs.
Containers are typically leased out under three forms of leases: a short-term or trip lease for a round trip or other shod term use; a term lease for a definite period of time; a master lease under which equipment may be picked up and dropped off during the period of the lease with rent paid, subject to minimum usage, only while the equipment is being used.
It is not typical in the container leasing business for the equipment to be leased under lease purchase agreements or full-payout leases under which the customer agrees to pay sufficient rent for the lessor to recover the entire cost of the equipment.
The length of the leases differentiates the Sea Containers securitization transaction from most other equipment leasing securitization transaction. As recognized by the parties, the lenders to the SPV could not recover their loans from the leases in effect at the time of the closing. In order to generate the necessary cash flow to service the debt over a period of as long as seventeen years, the lease for every unit of equipment must be renewed or replaced many times.
In traditional securitization, the asset being securitized_such as a mortgage_is, in essence, a stream of payments. The investors' return comes in collecting the committed stream of payments to be made by the borrowers. The same is true of an equipment leasing transaction where the equipment is subject to a "full-payout" lease commonly including a hell or high water clause by which the lessee agrees to make the rent payments despite any problems which it may later experience with the equipment. In such a structure, the credit risk for the investor is the credit of the borrower or lessee and it need not depend on the Originator since, if the Originator is no longer able to act as the Servicer in collecting the payments, a number of financial institutions, including the bank which is acting as the trustee for the securities, may be able to step in and make the collections. In contrast, the container leasing business is an international service business with world-wide customers and operations. The Servicer must have locations and personnel throughout the world to accept redelivery of equipment and negotiate new leases for the equipment.
In the Sea Containers transactions much more so than the typical transaction, the parties were concerned with the terms of the servicing agreement and the ability of the Servicer to perform. The parties intended that Sea Containers continue to lease out the equipment subject to the securitization transaction as part of its overall fleet of equipment without introducing operating difficulties to account for the ownership of a portion of its portfolio of equipment by the SPV. The transaction was able to go forward when, satisfied that Sea Containers would continue to perform its obligations under the servicing agreement, the parties were able to balance their competing interests in the terms of the management agreement.
The transaction meant a large savings in interest expense for Sea Containers (about 1% for up to $200 million in indebtedness). The senior notes sold to a commercial paper conduit bear interest at a modest spread over commercial paper rates. The revolving subordinated notes sold to a bank bear interest at a LIBOR rate. By diversifying its sources of funding to include the commercial paper market, Sea Containers reduced its outstanding bank debt, replacing it, in part, with the securitized debt with reduced recourse and fewer restrictive covenants.
James Gadsden is a partner in the law firm of Carter, Ledyard & Milburn in New York, NY.
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|Title Annotation:||includes related article on Sea Containers Ltd.'s securitization transaction|
|Date:||Mar 1, 1998|
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