# Presentation: 341661

## FDIC conference

- Asset Backed Securities:
- Costs and Benefits of
- “Bankruptcy Remoteness”
- Ken Ayotte and Stav Gaon
- Columbia Business School

- Ken Ayotte

## ABS Transaction Structure

- Originator

- Assets
- (Receivables)

- $

- “Structured financings are based on one central, core principle: a defined group of assets can be structurally isolated, and thus...[is] 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

- Ken Ayotte

## 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?

- Ken Ayotte

## 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?**

- Ken Ayotte

## Model timeline

- Xh2

- Ken Ayotte

## Setup and intuition

- The firm generates two kinds of assets:
*Replaceable assets (receivables): *
- Non-contractible liquidation value* L**r*
- 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.

- Ken Ayotte

## 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

- Ken Ayotte

## 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)

- Ken Ayotte

## 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.**

- Ken Ayotte

##  Adding ABS: Replaceable assets only

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

- Ken Ayotte

## ABS with necessary assets: inefficient bargaining in bankruptcy

- Suppose some assets are necessary to invest in bankruptcy: **L****n**** > 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* > Ln: firm may reject when continuation is efficient, i.e. *inefficient bargaining leads to inefficient liquidations*

- Ken Ayotte

## Alternative to ABS:Secured 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***

- Ken Ayotte

## Effects of secured creditor dilution

- We assume if lender is secured by collateral worth L, that        is senior to DIP lender; δ<1 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

- Ken Ayotte

## 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 *

- Ken Ayotte

## 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 Debtor’s 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!*

- Ken Ayotte

## 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 judge’s 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***”

- Ken Ayotte

## Example of an ABS prospectus post-LTV 

- “If the seller were to become a debtor in a bankruptcy case, and...the seller itself as debtor-in-possession were to take the position that the RRB property constituted property of the seller’s bankruptcy estate, and a court were to adopt this position...then 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

- Ken Ayotte

## 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

- Ken Ayotte

## 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

- Ken Ayotte

## Regression analysis

- Ken Ayotte

## 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

- Ken Ayotte