However, suppose that Ace Corporation can create another legal entity and sell the loans to that entity. That entity is the SPV that we described in Chapter 1 in our hypothetical transaction (FACET). If the sale of the loans is done properly—that is, there is a true sale of the loans—FACET then legally owns the receivables, not Ace Corporation. This means that if Ace Corporation is forced into bankruptcy, its creditors cannot recover the loans sold to the SPV because they are legally owned by FACET.

The implication of structuring a transaction by using FACET, the SPV, is that when FACET sells bonds backed by the loans (i.e., the asset-backed securities), the rating agencies will evaluate the credit risk associated with collecting the payments due on the loans independent of the credit rating of Ace Corporation. That is, the credit rating of the originator/seller (Ace Corporation) is not relevant. The credit rating that will be assigned to the bond classes issued by FACET will be whatever the issuer wants the credit rating to be! It may seem strange that the issuer (FACET) can get any credit rating it wants, but that is the case. The reason is that FACET will show the characteristics and historical performance of similar loans in the securitization transaction to the rating agencies from whom ratings for the bond classes are being sought. In turn, the rating agencies evaluating the bonds classes will tell the issuer how the transaction must be structured in order to obtain a specific rating for each of the bond classes in the structure. More specifically, the issuer will be told how much credit enhancement is required in the structure to be award a specific credit rating to each bond class.

By credit enhancement it is meant that there is a source of capital that can be used to absorb losses incurred by the asset pool. There are various forms of credit enhancement that we review in Chapter 5. Basically, the rating agencies will evaluate the potential losses from the collateral and determine how much credit enhancement is required for the bond classes in a proposed structure to achieve the targeted rating sought by the issuer. The higher the credit rating sought by the issuer, the more credit enhancement a rating agency will require for a given collateral. Thus, Ace Corporation, which we assumed is single-B rated, can obtain funding using the loans to its customers as collateral to obtain a better credit rating for one or more of the bond classes it issues than its own credit rating. In fact, with enough credit enhancement, bond classes backed by the collateral can be awarded the highest credit rating, triple A. The key to a corporation issuing bonds via a securitization with a higher credit rating than the corporation’s own credit rating is the SPV. Its role is critical because it is the SPV that legally separates the assets used as collateral for the securitization from the corporation that is seeking financing (the originator/seller), thus insulating the transaction from the credit risk of the originator. The SPV itself is structured as a bankruptcy-remote entity. Thus, we are left with the risk of losses in the asset, or credit risk, which can be mitigated by proper credit enhancements to a point where the target rating can be achieved.

Even after factoring in the cost of credit enhancement and other legal and accounting expenses associated with a securitization, capital seeking firms have found securitization to be a less expensive than issuing corporate bonds. For example, consider the auto manufacturers. In 2001, the rating downgrades of the firms in this industry pushed Ford Motor, General Motors, and Toyota Motor to issue in early 2002 asset-backed securities backed by auto loans rather than issue corporate bonds. Ford Motor Credit, for example, issued $5 billion in the first two weeks of 2002. Since 2000, when there was the first threat of the parent company’s credit rating, Ford Motor Credit reduced its exposure from $42 billion to $8 billion, substituting the sale of securitized car loans that were rated triple A. In fact, from 2000 to mid-2003, Ford Motor Credit increased securitizations to $55 billion (28% of its total funding) from $25 billion (13% of its total funding). Also, while the ratings of the auto manufacturers were downgraded in May 2005, the ratings on several of their securitization transactions were actually upgraded due to high subsisting levels of credit enhancement.

While we explained the difference between the legal preference that an investor in a securitization has compared to that of an investor in a secured debt obligation of an issuer, the question is why a corporation cannot provide this legal preference without selling the assets to an SPV. The reason is that the prevailing legal structure does not permit the isolation of specific assets that is free from the claims of the corporation’s other creditors if it has financial difficulty. Hence, securitization is basically a form of “legal” arbitrage.

While we have stated that investors in a securitization are protected from the creditors of the originator/seller when there is a true sale, in the United States the truth of the sale has been directly challenged in the courts. The bankruptcy of LTV Steel Company, Inc. (LTV), filed in the United States Bankruptcy Court for the Northern District Court of Ohio on December 29, 2000, was the closest challenge. LTV argued that its two securitizations (a receivables securitization and an inventory securitization) were not true sales but instead disguised financing transactions. If this were upheld by the bankruptcy court, the creditors of LTV would have been entitled to the cash flow of the assets that LTV allegedly merely transferred but did not sell to the SPV. Based on this argument, LTV in an emergency motion to the bankruptcy court sought permission to use the cash flow of the assets that were the collateral for the two securitizations as long as it provided adequate protection to the investors in the asset-backed securities issued by the SPV. In an interim order, the bankruptcy court did allow LTV to use the cash flow from the assets that were the collateral for the securitization. However, the bankruptcy court did not have to eventually rule on this argument of whether there was a true sale of the assets because the case was settled. As part of a settlement, there was a summary finding that the securitizations of LTV were in fact a true sale. Troubling to investors in asset-backed securities is that the court decided to permit LTV to use the cash flows prior to the settlement.⁵

The risk management capability of securitization is not limited to banks. For example, consider once again Ford Motor Credit. Since 2000, it used securitization to reduce its car loan portfolio and thereby reduce its exposure to the credit risk associated with those loans. At the end of 2001, Ford Motor carried $208 million in auto loans and realized first quarter credit losses of $912 million. By 2003, credit losses for the first quarter declined to $493 million with loans on the balance sheet down by $28 million to $180 million.

The central idea underlying risk-based capital guidelines is the regulatory requirement of a direct link between capital reserves and the credit risk associated with a regulated financial entity’s portfolio of assets. The risk associated with each asset is quantified by assigning a risk weight to each asset category. Upon classifying the assets held by a financial entity into the various risk categories, the risk-weighted value for that category is determined by weighting the book value of the asset category by the risk weight. The total capital reserves required by the financial entity are then determined as a percentage of the total risk-weighted asset values. All things equal, institutions that hold a risky portfolio have to reserve a higher amount of capital. Since securitization results in lower retained risk with the originator, capital guidelines, which are risk-sensitive, require presumably lesser capital in the case of securitization than in the case of the unsecuritized portfolio of loans. As a result, frequently a regulated financial entity can lower its regulatory capital requirements by securitizing certain loans that it would normally retain in its portfolio. On the demand side, it should be noted that regulated financial entities would prefer to hold higher-rated securities backed by loans than hold the loans directly.

Moreover, the Enron bankruptcy prompted the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) to reexamine the use of off-balance-sheet transactions. Enron used SPVs for a variety of illegal purposes. This resulted in new SEC rules and FASB accounting rules for SPVs despite the fact that the use of SPVs in securitization had nothing to do with how SPVs were used to mislead investors by Enron.

The basic issue is whether or not the SPV should be consolidated with the corporation. Pre-2003 generally accepted accounting principles (GAAP) for consolidation required that a corporation consolidate if it had a “controlling financial interest.” The definition of controlling financial interest was that the firm had a majority voting interest. Hence, GAAP’s pre-2003 rules set forth that a corporation could be the primary beneficiary of the activities of an SPV; but absent a majority voting interest, consolidation was not necessary.

The FASB on January 17, 2003 issued FASB Interpretation No. 46 (“Consolidation of Variable Interest Entities”), referred to as FIN 46, which set forth a complex set of rules and principles for consolidation of what is referred to as variable interest entities, one example being an SPV.⁷ If an SPV is consolidated, then the fair market value of the assets is reported on the corporation’s balance sheet as an asset. On the other side of the balance sheet, a fair value for the liability is recorded, as well as the fair market value of the minority interest in the SPV. While FIN 46 is complex and subject to interpretation, securitizations must comply with it in order to avoid consolidation for financial reporting purposes.⁸

With respect to SEC requirements, Section 401(a) of the Sarbanes-Oxley Act of 2002 (SOX) and its amendments deal with disclosure in periodic financial reports. With respect to off-balance-sheet transactions, SOX requires that a company in its annual and quarterly filings with the SEC disclose all material off-balance-sheet transactions, arrangements, obligations (including contingent obligations), and other relationships of the issuer with unconsolidated entities or other persons, that may have a material current or future effect on financial condition, changes in financial condition, results of operations, liquidity, capital expenditures, capital resources, or significant components of revenues or expenses.

The amendments to SOX address the lack of transparency of these transactions in a public company’s financial disclosure by requiring a discussion of them in a separate section within the management discussion and analysis section in SEC filings that it is reasonable to assume will have an effect on not only the firm’s financial condition but other matters material to investors. With a greater understanding of a company’s off-balance-sheet arrangements and contractual obligations, investors will be better able to understand how a company conducts significant aspects of its business by using securitization, for example, and to assess the quality of a company’s earnings and the risks that are not apparent on the face of the financial statements.