Timothy C. Leixner
HOLLAND & KNIGHT LLP
Mortgage backed (MBS) and asset backed (ABS) securitizations, or more generally, the securitization of financial assets (for purposes of this outline, Securitizations), is a form of structured finance initially developed in the early 1980's in MBS format. It matured in the late 1980's in both MBS and ABS formats and is now a $400 billion industry in the U.S. alone. In recent years, it has spread to Europe (the largest market outside the U.S.), Latin America and Southeast Asia (primarily Japan).
Virtually all forms of debt obligations and receivables (Receivables) have been securitized in the U.S.: residential mortgages; home equity loans; manufactured housing loans; timeshare loans; auto, truck, RV, aircraft and boat loans and leases; credit card receivables; equipment loans and leases; small business loans; student loans; trade receivables (just about any type, i.e., airline tickets, telecommunications receivables, toll road receipts); lottery winnings; and record album receivables (David Bowie and Pavarotti). Although the basic concepts, many based upon tax and accounting effects and desired results, are essentially the same, each asset class presents unique structuring considerations, and the players are constantly looking for ways to improve structures to achieve higher ratings (and thus lower costs) and reduced expenses. Securitizations outside the U.S. have been more limited because of certain impediments (discussed below). In Latin America the principal asset class securitized has been trade receivables (primarily the "future flow" from trade receivables, discussed in more detail below).
In its simplest form a Securitization involves (1) the sale of a large pool of Receivables by an entity (Originator) that creates such Receivables (or purchases the Receivables from entities that create them) in the course of its business to a "bankruptcy-remote," special purpose entity (SPE) in a manner that qualifies as a "true sale" (vs. a secured loan) and is intended to achieve certain results for accounting purposes, as well as protecting the Receivables from the claims of creditors of the Originator, and (2) the issuance and sale by the SPE (Issuer), in either a private placement or public offering, of debt securities (Securities) that are subsequently satisfied from the proceeds of and secured by the Receivables. When the Securitization is "closed," funds flow from the purchasers of the Securities (Investors - usually banks, insurance companies and pension funds) to the Issuer and from the Issuer to the Originator. All of these transactions occur virtually simultaneously.
In the United States, the Issuer in the basic structure is normally a trust (grantor, owner or business, depending upon the Originator's objectives and the structure), which issues Securities consisting of notes or other forms of commercial paper (Notes) and certificates evidencing an undivided ownership in the Issuer (Certificates). Frequently, there is also created a residual interest in the Issuer that entitles the holder (usually the Originator) to funds remaining after all obligations to the holders of the Notes and Certificates (Securityholders) have been satisfied. During the term of the Securitization, payments on the Receivables are collected by a servicing entity, usually the Originator (Servicer), deposited and invested (in "eligible securities") in various accounts under the control of a trustee (Trustee), and disbursed by the Trustee to the Securityholders in payment of the Securities.
In many instances a "two step" structure has been used whereby the Receivables are first transferred by the Originator to an intermediate SPE (Intermediate SPE) that is a wholly owned subsidiary of the Originator, but which is only permitted to engage in the business of acquiring, owning and selling the Receivables, has at least one independent director and is restricted in various ways from entering into voluntary bankruptcy and other prohibited acts. Frequently, this transfer is, at least in part, a contribution of capital by the Originator to the Intermediate SPE. In the second of the "two steps," the Intermediate SPE sells the Receivables to the Issuer. This structure is intended to enhance the "true sale" and "bankruptcy remote" characteristics of the transaction. That is, the transaction is structured to insure that the sale of Receivables to the Intermediate SPE is a "true sale" rather than a financing device, which is necessary for the Originator to get the Receivables off its balance sheet and book a profit or loss for accounting purposes and, combined with the second transfer by the Intermediate SPE to the Issuer, an essential part of the required protection from the claims of creditors, including by avoiding consolidation of the Receivables with the assets of the Originator in the event of the bankruptcy of the Originator. Beginning in 1997, a change in accounting rules in the U.S. pursuant to FASB 125 has virtually mandated the use of the two step structure to obtain an "isolation of assets" and, therefore, a "true sale," whenever the Originator retains an interest in the Securities issued by the Issuer (usually for credit enhancement purposes, as discussed below). However, it should be noted that in some cases the Originator does not want a true sale to occur (and book a gain or loss) and deliberately structures the transaction as a secured loan.
The above description of the Securitization structure is very basic. Actual structures involve many more elements and participants. The classes of assets also result in different and, in many cases, more complex structures. For example, in securitizing motor vehicle leases, to avoid the very high costs of multiple transfers of titles to the vehicles, a new structure was developed several years ago (in which the author of this outline participated) where the vehicles are initially titled in and the leases made through an "origination trust" and that trust then issues, in a series of complex transfers to other trusts, limited partnerships and limited liability companies, units and sub-units of beneficial interest in the trust which are actually the "receivables" that are securitized, the Securityholders having no interest, beneficial or otherwise, in the underlying vehicles or leases.
The Securitization structure is intended to provide significant advantages to Originators, such as:
1. The Receivables are moved "off balance sheet" and replaced by a cash equivalent (less expenses of the Securitization), thus improving the Originator's balance sheet and resulting in gain or loss, which itself is usually an intended, beneficial consequence.
2. The Originator does not have to wait until it receives payment of the receivables (or, in a "future flow" securitization, until it even generates them) to obtain funds to continue its business and generate new Receivables. In many cases this is essential, and a role otherwise filled by more traditional methods of financing, including factoring (in some ways Securitization is a very sophisticated form of factoring). This is more significant when the Receivables are relatively long term, such as with real property mortgages, auto loans, student loans, etc., and not as significant with short term Receivables, such as trade and credit card Receivables.
3. The Securities issued in the Securitization are more highly rated by participating rating agencies (because of the isolation of the Receivables in a "bankruptcy-remote" entity), thus reducing the cost of funds to the Originator when compare to traditional forms of financing. In instances where the Receivables bear interest, there is usually a significant spread between the interest paid on the Securities and the interest earned on the Receivables. Ultimately, the Originator receives the benefit of the spread. In addition, the Originator usually acts as Servicer and receives a fee for its services.
4. In non-revolving structures, and those with fixed interest rate Receivables, assets and related liabilities can be matched, eliminating the need for hedges.
5. Because the Originator usually acts as Servicer and there is normally no need to give notice to the obligors under the Receivables, the transaction is transparent to the Originator's customers and other persons with whom it does business.
These advantages are tempered by the fact that the Securitization structure results in higher costs than traditional forms of financing, but this is more than offset by the advantages. However, these higher costs mean that the value of a pool of Receivables must be significant to justify Securitization. An offering of Securities in a Securitization should be valued at $30,000,000 or more and most are in excess of $100,000,000, a number even in excess of $1 billion. In fact, most Securitizations at the low end are not structured by the Originators, but use "conduit" Issuers maintained by banks and investment bankers. In these securitizations, Originators sell Receivables to conduits that aggregate Receivables from multiple Originators (even different forms of Receivables) to create large pools to support the Securities issued by the Issuer-conduit. Because the operators of the conduits keep a bigger share of the "pie," an Originator is usually better off structuring a Securitization that uses its own Issuer in a "stand-alone" Securitization when its pool of Receivables is sufficiently large.
The major "players" in the securitization game, all of whom require legal representation to some degree, are as follows (this terminology is typical, but different terms are used; for example the "originator" is often referred to as the "issuer" or "seller"):
Originator - the entity that either generates Receivables in the ordinary course of its business, or purchases and assembles portfolios of Receivables (in that sense, not a true "originator"). Its counsel works closely with counsel to the Underwriter/Placement Agent and the Rating Agencies in structuring the transaction and preparing documents and usually gives the most significant opinions. It also retains and coordinates local counsel in the event that it is not admitted in the jurisdiction where the Originator's principal office is located, and in situations where significant Receivables are generated and the security interests that secure the Receivables are governed by local law rather than the law of the state where the Originator is located.
Issuer - the special purpose entity, usually an owner trust (but can be another form of trust or a corporation, partnership or fund), created pursuant to a Trust Agreement between the Originator (or in a two step structure, the Intermediate SPE) and the Trustee, that issues the Securities and avoids taxation at the entity level. This can create a problem in foreign Securitizations in civil law countries where the trust concept does not exist (see discussion below under "Foreign Securitizations").
Trustees - usually a bank or other entity authorized to act in such capacity. The Trustee, appointed pursuant to a Trust Agreement, holds the Receivables, receives payments on the Receivables and makes payments to the Securityholders. In many structures there are two Trustees. For example, in an Owner Trust structure, which is most common, the Notes, which are pure debt instruments, are issued pursuant to an Indenture between the Trust and an Indenture Trustee, and the Certificates, representing undivided interests in the Trust (although structured and treated as debt obligations), are issued by the Owner Trustee. The Issuer (the Trust) owns the Receivables and grants a security interest in the Receivables to the Indenture Trustee. Counsel to the Trustee provides the usual opinions on the Trust as an entity, the capacity of the Trustee, etc.
Investors - the ultimate purchasers of the Securities. Usually banks, insurance companies, retirement funds and other "qualified investors." In some cases, the Securities are purchased directly from the Issuer, but more commonly the Securities are issued to the Originator or Intermediate SPE as payment for the Receivables and then sold to the Investors, or in the case of an underwriting, to the Underwriters.
Underwriters/Placement Agents - the brokers, investment banks or banks that sell or place the Securities in a public offering or private placement. The Underwriters/Placement Agents usually play the principal role in structuring the transaction, frequently seeking out Originators for Securitizations, and their counsel (or counsel for the lead Underwriter/Placement Agent) is usually, but not always, the primary document preparer, generating the offering documents (private placement memorandum or offering circular in a private placement; registration statement and prospectus in a public offering), purchase agreements, trust agreement, custodial agreement, etc. Such counsel also frequently opines on securities and tax matters.
Custodian - an entity, usually a bank, that actually holds the Receivables as agent and bailee for the Trustee or Trustees.
Rating Agencies - Moody's, S&P, Fitch IBCA and Duff & Phelps. In Securitizations, the Rating Agencies frequently are active players that enter the game early and assist in structuring the transaction. In many instances they require structural changes, dictate some of the required opinions and mandate changes in servicing procedures.
Servicer - the entity that actually deals with the Receivables on a day to day basis, collecting the Receivables and transferring funds to accounts controlled by the Trustees. In most transactions the Originator acts as Servicer.
Backup Servicer - the entity (usually in the business of acting in such capacity, as well as a primary Servicer when the Originator does not fill that function) that takes over the event that something happens to the Servicer. Depending upon the quality of the Originator/Servicer, the need and significance of the Backup Servicer may be important. In some cases the Trustee retains the Backup Servicer to perform certain monitoring functions on a continuing basis.
Credit enhancements are required in every Securitization. The nature and amount depends on the risks of the Securitization as determined by the Rating Agencies, Underwriters/Placement Agents and Investors. They are intended to reduce the risks to the Investors and thereby increase the rating of the Securities and lower the costs to the Originator. Typical forms of credit enhancement are:
1. Over-collateralization - transferring to the Issuer, Receivables in amounts greater than required to pay the Securities if the proceeds of the Receivables were received as anticipated). The amount of over-collateralization (usually 5% to 10%) is determined by the Rating Agencies and the Underwriters/Placement Agents, and this in turn will depend upon the quality of the Receivables, other credit enhancement that may be available, the risk of the structure (such as the possible bankruptcy of the Originator/Servicer), the nature and condition of the industry in which the Receivables are generated, general economic conditions and, in the case of foreign-based Securitizations, the "Sovereign risk" (see discussion below under "Foreign Securitizations"). If all goes well, it is repurchased at the end of the transaction (see "Anatomy of a Securitization")or returned as part of the residual interest. This form of credit enhancement is required in virtually all Securitizations.
2. Senior/subordinated structure - issuance of subordinated or secondary classes of Securities, which are lower-rated (and bear higher interest rates) and sold to other Investors or held by the Originator. In the event of problems, the higher rated (senior) Securities receive payments prior to the lower rated (subordinated) Securities. It is not uncommon for there to be a number of classes of Securities that are each subordinated to the more highly rated, resulting in a complex "waterfall" of payments of principal and interest. In the common structure described above, senior and subordinated classes of Notes would be paid, in order of priority, prior to classes of Certificates, and Certificates prior to any residual interest in the Issuer. This form of credit enhancement has become routine, but cannot be used in a grantor trust structure, which is why the owner trust has become most common.
3. Early amortization - if certain negative events occur, all payments from Receivables are applied to the more senior securities until paid. Very common.
4. Cash collateral account - the Originator deposits funds in account with Trustee to be used if proceeds from Receivables are not sufficient. Adjustable depending upon events. May be in the form of a demand "loan" by the Originator to the account.
5. Reserve fund - subordinated Securities retained by the Originator or Trustee and pledged for the benefit of the Trust (and, therefore, the Investors).
6. Security bond - guarantee (or wrap) of all payments due on the Securities. Issued by AAA-rated monoline insurance companies (if available).
7. Liquidity provider - in effect, a guarantee by the Originator (or its parent) or another entity of all or a portion of payments due on the Securities.
8. Letter of credit (for portion of amounts due on Securities) - not used much anymore because of costs. These were common in the late 1980's when issued by Japanese banks at low rates.
Legal opinions are very important documents in every Securitization and result in considerable negotiations among counsel for the Originator, Underwriter/Placement Agent and Rating Agencies. The opinions given by the Originator's counsel are the most extensive, frequently running 50 or more pages because of the need for reasoned opinions, as courts have not ruled upon many of the underpinnings of the Securitization structure. In addition to the usual opinions regarding due organization, good standing, corporate power, litigation, etc, others deal with the validity and priority of security interests, true sale vs. secured loan, substantive consolidation in bankruptcy, fraudulent transfer, tax consequences and compliance with securities laws and ERISA. Opinions are also given by counsel for the Trustees and frequently by counsel to the Underwriter/Placement Agent in regard to tax and securities matters. As indicated above, local counsel opinions may be required as well.
For reasons of structuring and such opinions, in addition to attorneys who are experienced in Securitizations, expertise is required in the areas of securities law, tax law, bankruptcy and the UCC. Expertise is also required in many instances in the substantive laws relating the business of the Originator and the nature of the Receivables.
This Securitization structure has presented problems in civil law-based countries, where the concepts of trust law have traditionally not existed. In addition, in many countries there are concerns about government intervention in the international flow of funds and other aspects of Securitizations, the ability of the Servicer and Trustee to enforce the collection of Receivables in a commercially reasonable manner, additional tax burdens, the unpredictable nature of courts and government instability. These are known as the "sovereign risk" and have either completely blocked in-country Securitizations or have resulted in ratings of the Securities no higher than the rating of the country. As a result, many Securitizations, particularly those involving Latin American originated Receivables, have used a structure where the Receivables are transferred to offshore entities ("offshore" may be in the U.S.) and the entire transaction takes place outside the country of origin.
This situation continues to prevail in most countries, but a few have adopted legislation to permit the limited use of trusts (Argentina and Brazil) or the creation of special purpose corporations to serve the same purpose (France). However, even where such legislation has been adopted, sovereign risk issues may prevent a Securitization that is able to take advantage of international money markets, particularly outside of Western Europe. Further, such legislation has often been incomplete or flawed. For example, Securitizations are rarely based in France because it decided it should impose a tax on the special purpose corporations permitted under the new law.
Nevertheless, economic and financial market conditions in many countries have provided strong incentives for Originators in countries such as Brazil and Argentina, and the non-US market is growing every year, although the Asian and South American markets are very difficult at this time. Moreover, because of a lack of experienced underwriters, trustees and attorneys in most countries, many such service providers have expanded into Europe and Latin America.
In Latin America, one of the most common asset classes is "future flow"
receivables. In this type of Securitization, involving trade receivables
of short duration, only a relatively small amount of existing Receivables
are transferred to the Issuer and the Investors purchase Securities with
a much higher face value based upon the subsequent transfer by the Originator
to the Issuer of a "future flow" of Receivables to be generated by the
Originator with the proceeds of the Securitization. In effect, the Originator
receives payment for Receivables that do not exist, and will only come
into existence through the future conduct of the Originator's business.
Obviously, this can only be accomplished by Originators with strong track
records and engaged in businesses with a high likelihood of continuing
at profitable levels. In addition, it usually involves foreign Receivables
that can readily be transferred and collected offshore. An example of this
is the Securitization of airline ticket receivables by Varig.
Wednesday, September 01, 1999