False Security?

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

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?

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