FDIC conference

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FDIC conference

• Asset Backed Securities
• Costs and Benefits of
• Bankruptcy Remoteness
• Ken Ayotte and Stav Gaon
• Columbia Business School

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ABS Transaction Structure
Assets (Receivables)

Originator
Structured financings are based on one central,
core principle a defined group of assets can be
structurally isolated, and thusis independent
from the bankruptcy risks of the originator
Committee on Bankruptcy and Corporate
Reorganizations of the Association of the Bar of
the City of New York
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Main questions

• From a corporate finance perspective, what makes
  asset-backed securities (ABS) differ from other
  existing financing tools (secured debt)?
• How do differences in bankruptcy treatment of
  securities affect firms capital structure,
  investment decisions?
• Is bankruptcy remoteness valuable to investors?

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Prevailing explanations for securitization

• ABS allows a firm of moderate credit quality to
  borrow cheaply by issuing a safe instrument
• Modigliani-Miller so what? Does ABS create
  value?
• Avoiding bank regulatory capital requirements
• Many industrial firms securitize
• Moral hazard, adverse selection (Iacobucci/Winter
  2003)
• Prevents diversion of free cash flow
• Securitizing transparent assets, keeping opaque
  assets alleviates lemons problem
• But what distinguishes ABS from secured debt?

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Model timeline
Xh2
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Setup and intuition

• The firm generates two kinds of assets
• Replaceable assets (receivables)
• Non-contractible liquidation value Lr
• Can be acquired in a competitive market from many
  sources
• Necessary assets (inventory, patents,
  trademarks)
• Non-contractible liquidation value Ln
• The firm requires timely access to them in order
  to survive
• Assumption the firm needs K in replaceable
  assets and the necessary assets in order to
  reorganize
• Intuition
• Manager wants to commit to efficient investment
  decisions to maximize equity value.
• Capital structure facilitates commitment.

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Securities

• Securities differ only in their control and cash
  flow rights in bankruptcy, based on rules and
  practice in Chapter 11
• Unsecured debt is junior to DIP lender
• Secured debt is senior to unsecured, seniority to
  DIP lender depends on liquidation value of
  collateral
• Asset-backed securities (ABS) are
  bankruptcy-remote the transaction is a true
  sale and SPV owns the collateral
• Leases are call options for the firm see paper

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Ensuring ex-post efficient investment

• Efficiency condition continuation is ex-post
  efficient if and only if
• Which reduces to
• Goal in setting capital structure is to minimize
  expected costs of inefficient investment (shown
  here for non-random Ln)

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When does continuation occur?

• Continuation will occur if DIP lender finds it
  profitable to lend this depends on the capital
  structure in place
• Suppose the firm is financed with all unsecured
  debt
• Then continuation occurs if and only if
• Recall that the efficiency condition is
• Here, inefficient continuation will occur,
  inefficient liquidation will not DIP finance
  leads to overinvestment through dilution of
  unsecured creditors.

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Adding ABS Replaceable assets only

• Suppose no necessary assets Ln 0
• Suppose the firm securitizes (sells) a fraction
  f of its replaceable assets at date zero
• Then the continuation condition is
• Identical to efficiency condition when f 1.
• First-best is obtained by securitizing all
  assets-in-place.
• Examples of this in practice revenue streams
  from hotel chains, restaurants (Arbys)

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ABS with necessary assets inefficient
bargaining in bankruptcy

• Suppose some assets are necessary to invest in
  bankruptcy Ln gt 0. Suppose the firm chooses to
  securitize everything.
• In order to continue, the firm must bargain with
  the SPV investors to get the assets back
• ABS investors observe Ln but not p2 make
  take-it-or-leave-it offer to firm to sell asset
  back for M
• Optimal offer price M gt Ln firm may reject when
  continuation is efficient, i.e. inefficient
  bargaining leads to inefficient liquidations

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Alternative to ABSSecured debt

• Secured debt Automatic stay allows firm to keep
  control of collateral can use it subject to
  providing adequate protection
• For several reasons, this protection is not as
  valuable as ability to seize collateral on demand
• No compensation for time value of money lost
  during reorganization
• Court can issue priming lien (364(d)) that
  allows DIP lender to trump a secured creditor
• Existing Chapter 11 practice allows secured
  creditors to be diluted this is the value of
  bankruptcy remoteness to ABS investors

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Effects of secured creditor dilution

• We assume if lender is secured by collateral
  worth L, that is senior to DIP lender dlt1
  represents dilution of secured claim in
  bankruptcy
• Suppose all assets are financed with secured
  debt. Then continuation condition becomes
• Recall that efficiency condition is
• Secured debt leads to inefficient continuations
  inefficiency is larger when dilution is greater

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Intuition Costs and Benefits of Bankruptcy
Remoteness

• With replaceable assets (receivables), informed
  DIP lending market naturally limits costs of
  creditor control
• No costs to maximizing creditor protection
• Secured debt leads to overinvestment
• So securitization is efficient
• With necessary assets (inventory, patents/
  trademarks) creditor control can produce
  inefficiencies
• Securitization leads to underinvestment
• Secured debt can be preferred court limits
  creditor control

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Testing the value of bankruptcy remoteness
the LTV Steel bankruptcy

• LTV Steel filed for Chapter 11 in Dec. 2000.
• Had ongoing securitization structures for
  accounts receivable and inventory
• LTV filed for Ch 11, argued that the
  securitization was really a secured loan in
  disguise
• Argued that purpose of transaction was for
  lenders to capture the most valuable assets of
  the Debtors to dispose of as they see fit, at a
  painful cost to the Debtors employees, unsecured
  creditors and shareholders
• Court issued interim cash collateral order that
  allowed LTV to use the securitization proceeds
• A securitization was recharacterized as a secured
  loan!

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Effects of the LTV decision

• From Dow Jones Newswires
• The bankruptcy-remote vehicle structure, the
  backbone of the debt securitization market, is
  facing a major challenge from a judges ruling in
  a bankruptcy filing by LTV Steel Corp
• Market sources say the decision could jeopardize
  the underpinnings for securitized debt issues,
  which depend upon the assets being earmarked for
  repayment being protected from bankruptcy
  proceedings

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Example of an ABS prospectus post-LTV

• If the seller were to become a debtor in a
  bankruptcy case, andthe seller itself as
  debtor-in-possession were to take the position
  that the RRB property constituted property of the
  sellers bankruptcy estate, and a court were to
  adopt this positionthen delays or reductions on
  payments on the bonds could result Some of these
  risks described in this section have been
  illustrated in the bankruptcy cases of LTV Steel
  Company

From PSNH Holdings, April 2001
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Empirical strategy

• If bankruptcy remoteness is an important
  protection for creditors, we should expect the
  uncertainty created by LTV to have increased
  credit spreads for Chapter 11-eligible
  originators
• Insured banks use FDIC insolvency procedure,
  rules explicitly prohibited recharacterization of
  ABS
• We use a difference-in-differences methodology,
  comparing ABS spreads pre- and post- LTV for
  insured depository and non-depository
  securitizers

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Data

• ABS data from SDC Platinum New Issues
• 1 year period surrounding LTV (Dec 29, 2000)
• AAA rated, fixed coupons
• Exclude GSEs, multi-seller conduits
• Maturity-matched swap rates from Datastream
• Bankruptcy/receivership status
• Identified originator from prospectus
• Bankruptcy/receivership risk identified in
  prospectus
• Insured bank status verified with FDIC records

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Regression analysis
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Conclusions

• Theory
• ABS can create value strongest protection
  against overinvestment due to bankruptcy
  remoteness
• ABS most valuable for replaceable assets for
  necessary assets, secured debt can be preferred
• Empirical analysis
• Creditor protection provided by bankruptcy
  remoteness is valuable and priced in financial
  markets