Friday, February 1, 2008

Nobody to Blame

Kelly's post about the life settlement backed securities market and the ensuing commentary, shakes up a conflict that runs through the legal academy on the subject of securitization. Some folks are agnostic about securitization by blissful ignorance. I suspect that among those of us who know something about what is going on, we divide into two camps: securitization lovers and securitization haters.

The disagreement is over the social value of "securitization"-- a term given to a transaction designed to separate an operating company's financial assets (payment obligations such as accounts receivable, vehicle leases, mortgage obligations, or life settlement contracts) from the risk assoicated with operating the company. A person (the obligor) incurs an obligation to pay the company over time for goods or services or contract rights or whatever. The company sells this obligation (the right to receive a stream of payments) to a third party. The third party issues securities to investors backed by the obligations.

The reason the company sells the obligations to a third party issuer rather than issuing its own securities directly to investors is to take advantage of the "remoteness" of the legally distinct third party from the operating company. The third party does nothing but hold the obligations it acquires and issue securities. Its value rests exclusively on the value of the obligations. It is immune from the ordinary operating risks borne by the company. As we say, it is "bankruptcy remote." If the company files for bankruptcy, the obligations are the third party's and not part of the company's bankruptcy estate. So, the rules that compel creditors of a debtor in bankruptcy to wait for payment, or take less payment from the debtor/company, will not affect the third party or its investors.

The whole point of introducing a bankruptcy remote entity into the finance transaction is to achieve bankruptcy remoteness for the ultimate investors, a benefit direct investors in the operating company do not enjoy. The benefit for the company is a reduced cost of capital relative to alternative finance structures. When the company is better off, its creditors and shareholders are better off. Or so the argument goes.

The third party's investors have the peace of mind that comes with bankruptcy remoteness. But the company's unsecured creditors feel differently. If the company succeeds, its unsecured creditors are happy. If the company fails and defaults, its unsecured creditors find the company's cupboard is bare when they try to foreclose on assets to satisfy their claims. True, the company received cash for the obligations from the third party when it sold them. But the cash is typically long gone to feed hungry secured creditors and stave off bankruptcy. When an operating company files for bankruptcy, its unsecured creditors usually end up holding the bag.Their suffering is made all the worse because the third party and its investors are sitting in a very comfortable bankruptcy remote catbird seat.

Before the emergence of securitization as a means of raising capital in the late 1980's, if a company with payment obligations wanted cash without issuing equity securities, it would borrow cash from a third party lender who would take a security interest in the obligations as collateral. From the company's perspective, both a sale of obligations for cash and a loan backed by obligations as collateral yield the same result: Both deploy illiquid assets (obligations) for liquid assets (cash).

The financial effects on the company of a sale of or loan against obligations are the same. But, the bankrutpcy effects are different. If the company pledges rather than sells its obligations to a third party then fails and files for bankruptcy, the obligations are still the company's and thus property of the company's bankruptcy estate (albeit subject to a security interest in favor of the third party). The third party lender becomes a secured creditor in the company's bankruptcy case, subject to all the heartache the debtor's bankruptcy can dish up to its creditors. Some observers of bankruptcy law think that the point of subjecting secured creditors to forced "compromise" in bankruptcy is to shift some of their wealth and power to unsecured creditors (and other groups) who have a stake in the survival of the debtor as a going concern. Under this view, what bankruptcy law forces secured creditors to give up does and should inure to the benefit of unsecured creditors, and so it seems, for the good of us all.

Unsecured creditors and the securitization hating academics who love them object to the idea that parties can by private agreement escape this effect by choosing a different transactional form (sale rather than loan) . Securitization haters believe that bankruptcy courts should and do have the power under the Bankruptcy Code to recharacterize a transaction the parties meant to be a sale to a bankruptcy remote entity as a secured loan from the third party to the company.

The fight among academics is ostensibly about what Congress meant to accomplish by the Bankruptcy Code. Most of us have in fact long given that up as utterly futile. So, we argue over whether securitizations maximize social welfare, or whether they are an inefficient drain on social welfare and are appropriately regulated by bankruptcy courts through recharcterization.

While bankruptcy academics snark about this, the securitization industry has put down roots deep into the economy. So far, only one bankruptcy court has recharacterized a securitization for the benefit of creditors, in In re LTV Steel (2001). Wall Street swooned. Since then, the sheer volume of securitized transactions has grown so large relative to the economy that if a bankruptcy court recharacterized a securitization today, the market would seize up. The economic fallout would make the current mortgage crisis look like a little after dinner indigestion.

The popular spin on securitization in the press these days is that securitization of mortgage backed obligations is to blame for the crisis in the mortgage market and corresponding instability in capital markets. Underbelly has an fresh perspective: Blaming 'securitization' for the recent mess is like blaming 'options' for the various meltdowns in the 90s--or like blaming airplanes for air crashes. Yes, it happened on their watch, but securitizations don't kill people, people k-- but you've heard that one before.

The voice of Underbelly, Buce Palookaville, concedes that two aspects of securitization transactions may have contributed to the current gloom. First, loan brokers (playing the role of the company in my hypothetical transaction) lured by up front commissions, apparently got stupid by greed and stopped caring about the quality of the obligations they generated. (This same kind of breakdown in underwriting infected corporate control deals in the 1980's and 1990's).

Second, there is nobody to blame when a securitization goes bad. When a loan tanks, the loan officer responsible for it is subject to humiliation at the bank and shunning at the country club. When a company fails after securitizing away its cash generating assets, the swarm of lawyers, bankers and rating agencies that put the deal together are in the wind. Securitization failures are failures without fault. And the blamelessness of it all shakes us lawyers to our cores.

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