Print this article | Return to Article | Return to CFO.comDebt in DisguiseThe boundaries between receivables securitizations and loans are blurring.Vincent Ryan, CFO MagazineNovember 1, 2007Why does WESCO International Inc. use accounts-receivables securitization, a form of financing soclosely linked to the subprime-mortgage meltdown? "Because we can," says senior vice president andCFO Stephen Van Oss.Van Oss is speaking only partly tongue-in-cheek. His company, a $5.3 billion distributor of electricalproducts, has a high-quality customer base and a robust IT platform for tracking the performance ofreceivables, capabilities demanded by banks and credit-rating agencies.But securitization is also cheap. "Its 60 to 80 basis points better pricing than any other asset-basedprogram," he says. "Its the most efficient way to borrow money."Indeed, low cost is a key reason all forms of asset-backed securitization (ABS) have flourished (see"What Lies Beneath" at the end of this article), reaching $1.2 trillion in outstanding issues of asset-backed commercial paper last July. Thats up 83 percent in three years, according to the SecuritiesIndustry and Financial Markets Association (SIFMA). The "other" category of outstanding asset-backedsecurities, which includes corporate trade receivables, has also grown, to $993 billion as of second-quarter 2007. That $993 billion was more than the dollar amount of securities backed by credit-cardreceivables and home-equity loans combined, according to SIFMA.The other advantage to ABS is that, unlike a loan, a corporation does not have to record it as debt.Securitization allows companies to transfer their trade receivables to a special-purpose entity, isolatingthem from the risks generally associated with the company. Accordingly, the SPE can raise money inthe capital markets at a lower price than the company could directly because the SPE can garner ahigher credit rating than the company as a whole (see "Anatomy of a Typical Securitization" at the endof this article).In light of the crisis in subprime mortgages, however, securitization doesnt seem as clever as it oncedid. "The subprime mess reminds the market that it matters what you securitize," says Adrian Katz,CEO of Finacity, an asset-backed financing company. "A securitization is ultimately only as good as thesecurity, the collateral."From a corporate perspective, another problem is that securitization vehicles may not be as safely offthe balance sheet as they seem. The legal structure has not been battle-tested in the courts, lawyersadmit. Employees may inadvertently cross invisible legal boundaries and invalidate these structuresaltogether. Some companies, WESCO among them, are putting them back on the balance sheet. That,in turn, reinforces the notion that receivables securitization is, in many ways, a secured bank loan indisguise — and a loan to a company that may be nowhere near investment-grade."What interests me is how this product got so big, when its legal underpinnings are arguably shaky,"says Ken Kettering, an associate professor at New York Law School.Speculative-Grade RootsTo date, no one has claimed that trade-receivables securities are as flawed as those backed bysubprime mortgages. Most securitization agreements come with representations and warranties thatprotect the cash flow, as well as credit enhancements like "overcollateralization," the posting of morecollateral than is needed to obtain financing.In addition, "because the underlying assets have a short duration (30 to 45 days), trade receivablesdont pose the same price volatility [risk] as a 30-year mortgage," says Katz. "The marked-to-markettype calls dont happen in trade receivables."
Still, part of what backs the commercial paper bought as triple-A credits are receivables fromcompanies that are junk or near-junk credits. For example, in 2003, with the help of Finacity, SprintCanada secured a five-year deal to sell its receivables to National Bank of Canadas commercial-paperconduit. Although the deal was A-rated, at the time Sprint Canada had senior secured notes deep inspeculative-grade territory. Similarly, Finacity helped create a $55 million program last year forAlliance One International, a single-B leaf-tobacco merchant, many of whose customers operate inemerging markets.Because the company that originates the receivables is still collecting the payments, servicing risk is aconcern in these deals, Katz admits. Indeed, Finacity "buttresses" the servicing capabilities of itsclients, he says, which tend to have less-robust systems than companies like WESCO. Finacity sets upthe SPE, collects on the accounts, monitors the creditworthiness of debtors, and reports daily onreceivables performance.But even Katz says, "Receivables are very gritty and lots of things can happen — partial payments,delayed payments, totally disputed payments. A lot depends on the operational abilities of the seller."And on the judgment of the rating agencies. The purpose of securitization is to make the credit ratingof the company practically irrelevant in a financing, so that even in a bankruptcy the receivables cashflow will be protected. The companies originating the securitization need the triple-A or near-triple-Astamp.In addition to the rating of the originating company (if available), rating agencies examine the creditand collection policies of the company, as well as debtor concentration in the receivables pool and theperformance record of receivables, says Ravi Gupta, a senior director in Fitchs ABS group. Triggersthat protect against dramatic declines in receivables performance — like those that set maximumlimits for defaults, dilutions, and delinquencies — are also factored in.But in reality, rating agencies rely more on risk mitigants such as liquidity lines from appropriatelyrated banks, and credit enhancements such as letters of credit. In a 2005 report, Fitch said that it"...places little or no reliance on the originators ability to meet its obligations if its [credit] rating isbelow that of the issued debt."The rating agencies also rely greatly on legal constructs that say the payment stream to investors willnot be hindered. For instance, the transfer of receivables to the SPE must be a "true sale." That is, theseller must not retain too much of the reward or the risk coming from the asset, says Robert Hahn, apartner with Hunton & Williams LLP. In addition, the SPE has to be "nonrecourse" — in other words,the companys creditors must not have claim to the assets of the SPE if the originating company goesbankrupt."Securitization divorces the creditworthiness of the [company] from the credit of the pool," says MarkSpradling, a partner with Vinson & Elkings LLP. "True sale and nonconsolidation are part of thatseparation."But the opinion that legal control of receivables has passed to a third party has not been litigated inthe bankruptcy courts. When LTV Steel declared bankruptcy in 2000, it filed for access to securitizedreceivables, arguing that its securitizations were "disguised financings." When a court agreed to hearLTVs arguments, stunned lenders quickly arranged debtor-in-possession financing for the company —provided it dropped its claims to the receivables. As a result, the issue has never been resolved in thecourts."Theres no bright-line test," says Spradling.Crossing a Fine LineThe delicate structure of securitizations is evident in the experiences of companies that have —sometimes accidentally — pierced the legal bubble on which this form of financing depends. AspenTechnology, a provider of process-optimization software, was forced to restate its financials goingback to 2005 because it inadvertently violated the true-sale structure of its securitization. Salespeopleat the company did so by licensing additional software to customers and consolidating the remainingbalance of older installment receivables into the new contracts. The securitization agreement did not
allow that in most cases. As a result, Aspen unintentionally regained control of some securitizedreceivables and was forced to alter its balance sheet.It also is relatively easy for a company to cross the nonrecourse boundary on purpose. At $2.3 billionVolt Information Sciences, a staffing firm that has a $200 million securitization program, a customerwith a large receivable whose debt was in the companys securitized pool filed for bankruptcy lastsummer."Technically, it was not mine to do anything with," says Volt senior vice president and treasurerLudwig Guarino, speaking of the debt. But when a debt buyer was willing to pony up 90 cents on thedollar, Guarino got Mellon Bank N.A., sponsor of the commercial-paper conduit into which Volt sells itsreceivables, to give Guarino a release on the lien. "The cash goes into the SPE, just like any othercash collection," Guarino says.Not all banks would have allowed such an arrangement. A key question in true-sale opinions is, afterall, "Is there recourse back to the seller on failure of performance of the asset? The more recoursethere is back to the seller, the less it looks like a sale and the more it looks like a loan," Spradlingsays. This, of course, was why many mortgage originators were reluctant to help strugglinghomeowners rework the terms of their loans this past summer.In July, under pressure from Congress, the Securities and Exchange Commission gave subprime-mortgage lenders permission to modify already-securitized home loans — if a default seemed likely —without taking the assets back on their balance sheets. The impact that guidance might have on othersecuritizations simply was not discussed. But clearly, the ability of corporations to deal with debt thathas been securitized is turning into more of a gray area.Accounting Calls It DebtTechnically, according to Financial Accounting Standard No. 140, SPEs in securitizations qualify for off-balance-sheet treatment. But some corporations that securitize receivables, desiring to bring financialreporting in line with economic reality, are bringing them back on balance sheet and calling themdebt. On-balance-sheet treatment, though, removes one of the prime advantages of securitization —raising capital without increasing the companys leverage.In December 2006, WESCO amended the accounting treatment of its $500 million securitizationprogram by including receivables sold on its balance sheet and labeling them secured borrowings. Thereceivables showed up as short-term debt, instead of just appearing in a note to accounts receivable,and the costs of the securitization appeared on the interest expense line."We did it primarily for transparency and good governance. It has made it a lot easier for people tounderstand, and we dont have to do reconciliation between GAAP and non-GAAP," says Van Oss. "Ithad no impact on the economics." The rating agencies did not downgrade the transaction nor did thecommercial-paper conduit ask for more collateral to reflect the new treatment. Dean Foods, a $10billion dairy-products maker, handles its securitization similarly, consolidating the assets of threeSPEs. Volt does also."Professionals — debt analysts, bankers, and equity analysts — all add [receivables] securitizationsback onto the balance sheet in figuring leverage and debt ratios," says Bob Finley, managing directorof Fifth Third Banks asset-securitization business. "Its window dressing at best. Lets just call it debt."Blowback from the era of Enron is one reason companies are tinkering with the accounting. More oftenthan not, though, non-investment-grade companies still want to be able to handle securitizations offbalance sheet, says Finacitys Katz, adding that the companies that move securitization back on thebalance sheet "are the companies that have the luxury of taking the high road."Too Big to Fail?Securitization is definitely in the sights of banking regulators. In the wake of last summers credit-markets crisis, the International Monetary Fund warned banking regulators not to stifle the "enormousbenefits" from financial innovation. But the IMF did call for a review of the different models by whichbanks pass on credit risk to investors. It also suggested that the rating agencies use different ratingsfor structured products and regular corporate debt.
If securitization were to go away or be drastically curtailed, says Van Oss, WESCO would just shift itsdebt to its slightly more expensive asset-based revolver.But even securitizations detractors admit it is probably here to stay. In the judgment of New YorkLaws Kettering, this form of structured finance is too big to fail. If there were ever a ruling in thebankruptcy courts that nullified the structures of true sale and bankruptcy-remote SPEs, the ratingagencies would have to downgrade all trade-receivables securitizations to the credit quality of theoriginators, he says."A court aware of the stakes is very unlikely to make such a ruling," says Kettering, "and should thatevent occur, Congress would bail out the product."Vincent Ryan is a senior editor at CFO.What Lies BeneathCalculating the Cost of SecuritizationTapping the capital markets without a lending bank in between means that even non-investment-grade companies can finance at near what triple-A companies pay.The "weighted average pool rate" that bank conduits charge to buy receivables is calculated on a dailybasis and includes an agreed-upon margin on top of the rate the bank pays.Short-term rates rose as high as 6 percent during last summers credit crunch, as bank conduits couldnot issue paper for longer than overnight, says William Rutkowski, a vice president in WachoviaCorp.s conduit-securitization group. But after the Federal Reserve Board cut rates, banks issued paperwith longer maturities, dropping commercial-paper rates to below 5 percent.In the past year, the cost of funds for securitization programs has started at 5.3 percent. However, insome securitization agreements, if the conduit cannot move its commercial paper, the rate passedthrough to the originator climbs to the prime rate or even LIBOR plus a set spread. If a portion of thereceivables securitization facility is unused, the originating company may also have to pay a programfee on that unused amount ranging from 100 to 400 basis points.CFOs also have to consider the costs of credit enhancement as well as those for the services oflawyers and investment bankers. For example, to ensure investors will not suffer losses from delayedcollections or defaults, the originator must sell to the special-purpose entity a level of receivables inexcess of the amount needed to pay for the securities issued. In most cases, "true-sale" treatmentrequires that any residual value from this "overcollateralization" not be available to the originator.For some companies, information-systems costs could be the highest hurdle. Without an upgrade, acompanys current systems may not be able to handle the ongoing and historical analysis ofdelinquency statistics, dilution figures, and breakdowns of customer concentrations that ratingagencies and bank conduits demand. — V.R.