Over the 50 years following the original Modigliani and Miller paper, several theories have been put proposed to explain why we observe less than 100% debt financing by firms. The leading explanation is that firms do not engage in 100% debt financing because of the costs of financial distress. A company that has difficulty making payments to its creditors is in financial distress. Not all companies in financial distress ultimately enter into the legal status of bankruptcy. However, extreme financial distress may very well lead to bankruptcy.⁶⁵ The relationship between financial distress and capital structure is straightforward: As more debt financing is employed, fixed legal obligations increase (interest and principal payments), and the ability of the firm to satisfy these increasing fixed payments decreases. Consequently, the probability of financial distress and then bankruptcy increases as more debt financing is employed. So, as the debt ratio increases, the present value of the costs of financial distress increase, reducing some of the value gained from the use of tax deductibility of interest expense.

The same type of question is being asked of asset securitization: Does asset securitization increase a firm’s value? Effectively, asset securitization breaks up a company into a set of various financial assets or cash flow streams. Some of those various subsets of financial assets are isolated from the general creditors of the originator and benefit solely the investors in the asset-backed securities issued. In a world without asset securitization each investor has a risk in the unclassified, composite company as a whole. There are, of course, secured lenders whose claims are backed by specific collateral, but such collateral value is also liable to be eaten up by the generic business risks of the entity. Does the decomposition of the company’s cash flow and granting specific debt holders a position of priority over other debt holders serve an economic purpose? If there is any advantage for this special category of debt holders with priority on the claims of designated financial assets, is it at the cost of the other investors in the firm, and, therefore, the aggregation of the risk-return profile of these different types of investors just the sum of a firm’s value without securitization?

Arbitrage activity is the most apparent example of the alchemy of securitization. An arbitrage vehicle acquires financial assets and funds the acquisition by issuing asset-backed securities, thereby making an arbitrage profit in the process. While there is no reason for the weighted average cost of the funding to be lower than the weighted average return from the assets acquired, the market proves that there is an arbitrage involved in stratifying the risks in the asset portfolio.

The principle of structural arbitrage is one of the principles in securitization. While this has been disputed by theorists, it has been observed quite clearly in the market. Schwarz (2002) argues that securitization does reduce funding costs and therefore is not a zero-sum game. His arguments are based on the economic rationale for secured lending: Because secured lending by definition puts the secured lender at priority to the unsecured one, costs are lowered. Schwarz also argues that securitization allows a firm to enter the capital market directly and certainly capital market funding is more efficient than funding by financial intermediaries. While financial intermediaries play an important function in terms of credit creation and capital allocation, funding should come from where it eventually comes—households.

While it may be true that credit enhancement using overcollateralization or some other mechanism is an inherent cost for the securitization transaction, what is important to understand is the nature of credit enhancement. In typical corporate funding, because equity investors are a firm’s first-loss capital, equity is the credit enhancement for the lenders to a firm. The extent of such credit enhancement in typical corporate funds, that is the appropriate leverage ratios for the firm, is in general extraneously specified either by lending practices or in the case of regulated entities such as banks, regulatory requirements. This may force a firm to require much higher credit enhancements in the form of equity than warranted. In contrast, in a securitization, the required credit enhancement is linked directly to the expected losses in the portfolio and, therefore, the risks of the portfolio of financial assets.

If it is accepted as true that equity is a costlier funding source than debt funding, the higher leverage requirements attributable to traditional lending to firms in an industry or by regulatory capital requirements imposing higher weighted average funding costs on the firm. Greater financial leverage is permitted by employing securitization and, therefore, a lower funding cost or correspondingly higher returns on equity are attainable. This is achieved not from more efficient operations but from higher leverage.

A rating arbitrage argument has been offered as to why one would expect securitization to result in lower weighted average costs. Rating arbitrage occurs because securitization allows the corporate ratings of the originator to remain unaffected and the transaction to be rated solely on the strength of its assets and the credit enhancement mechanisms in the structure. The auto industry provides an excellent example. When the U.S. automakers General Motors and Ford were downgraded, they did not reduce their securitization volume. In fact, the evidence as cited earlier indicates the opposite. Volumes not only increased, but the asset-backed securities received a triple-A rating. Moreover, the existing asset-backed securities outstanding prior to May 2005 were in fact upgraded to the triple-A level, essentially because of an increase in credit support levels.