False Security?

Corporate insolvencies are testing whether securitization is a stable structure or a flimsy facade.

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.”

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