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Securitisations - not quite as sexy as Bankers like to think.

Adapted from an article published in the October 2000 edition of The Treasurer by Brian Welch of The UserCare Treasury Consultancy and Gill Rowe, Treasurer of Arval PHH.

Introduction

Securitisations convert bundles of assets into structured financial instruments which are then negotiable (or tradeable). They raise funds which are backed by specific assets or by income flows, and a particular feature is the strict ‘ring fencing’ of particular assets or cash flows. This means that the financial instruments – such as medium term loans or commercial paper – can be assigned a higher credit rating than the actual borrower could command in their own right. This makes this kind of facility attractive to borrowers which are either unrated or have low ratings. As a result the issues usually need to be rated by the rating agencies – Moody’s and Standard and Poor’s. Road shows or presentations have to be prepared to explain in detail the activities and financial background to the company and the proposed loans, to those agencies and potential investors.  

 The important feature which gives the debt issue a higher rating, is the guarantee to the investor that if the borrower ceases trading for any reason, their loan is secure and will still be repaid.

 Whilst there is a place for securitisations in mortgage backed, property, and some other specialist sectors, there are serious drawbacks associated with managing them which means that they are not so suitable for more traditionally structured companies.

What are the drawbacks?

1.      Complexity

As their description suggests, securitisation or structured finance carries with it a very specific structure, which can be very complex and may restrict the borrower from having immediate access to some of its day to day cash flows. This also means strict adherence of a whole series of ratios, focussing on optimum cash generation. 

The securitisation structure will probably require the establishment of new “bankruptcy remote” companies to issue the debt, to receive the proceeds of the loans, and to handle the receivables. These companies each need access to bank accounts and, more importantly, the accounting needs to be more specific than within the conventional company structure. The assets eligible for the securitisation would need to be separated into these bankruptcy remote companies both in a legal and accounting sense.  The cash flows will also have to be segregated. The bank accounts may also need to be able to provide a range of sub accounts to cover reserves which may have to be made to cover a series of different provisions which the structure required.

If the existing accounting function is run in the typically frugal manner, additional personnel will almost certainly need to be employed because of the immediacy and detail of the reporting and accounting which is required.

The structure is managed for the borrower by the security trustee which will probably be provided by the lead bank, and the structure may well result in pools of cash being held separately within the ‘ring fence’ which can be managed to earn interest in a specified manner. 

The documentation is voluminous in the extreme, often requiring several dozen interrelated agreements.

2.      Reporting

The complexity of the documentation requires a much higher degree of reporting than under more usual banking facilities. Daily, weekly and monthly reporting of cash positions and asset information including relevant ratios is required. Information on assets will include details of individual assets providing the underlying security, both fixed assets and current assets, in order to determine the borrowing base. Eligibility assessments against the assets and daily reporting of cash collections and billings is a standard feature. The ratios may be further affected by the level of debt payment defaults, and other business data specific to the borrower or securitised assets.

3.      Cash Flow Management

Perhaps the most significant disadvantage is that, because of the fragmented nature of the cash flows which are either within or outside the arrangement, it is no longer possible to manage the corporate liquidity using conventional treasury techniques of pooling bank account balances. Bank accounts handling the cash on the securitised assets will be segregated from general pooling arrangements, although they may be allowed to be pooled amongst themselves. As the cash flows relating to the securitised assets or revenues pass straight to the security trustee, the amount of cash being passed on to the borrower by the security trustee may not be known, and certainly not received until well into the working day, by which time interest rates on the money markets are often past their best. Similarly payments relating to the operation of the company may have to be delayed until the cash flows are received from the security trustee.

4.      Activities outside of the Securitisation

Although other company activities may continue outside of the securitisation, it could be that they will be restricted, by the existence of a prior charge over the entire company’s assets, or by the fact that all of the borrower’s ‘good’ assets are tied up in the securitisation. This could impact on existing bank relationships, other borrowing facilities including overdrafts, and the ability to negotiate new business outside of the facility.

5.  Additional Advisors

Securitisations carry with them a multitude of professional advisors starting with the lead bank, which will probably also act as the funding agent and the security trustee. That bank will appoint its own lawyers which will also act for the other banks, but the borrowing company also needs to be advised by its own lawyers. There may also be the need for other professional trustees, and tax advice including reference of specific points to counsel. Other parties to the documentation, such as the main clearing bank will also consult its own lawyers concerning their own aspects of the documentation.

In addition, the borrower’s auditors are likely to be called upon not only to undertake audits of the assets and the reports, but also to provide various certificates concerning the assets and cash flows, tax positions and contingent liabilities. Auditors in general are becoming increasingly unhappy about these certificates because of the reliance which is being placed on them, and therefore need to be involved in the negotiations at a fairly early stage.

As previously described, the rating agencies play a big role in the structure of the deal and considerable management time will need to be spent with the lead bank and Standard & Poor’s and Moody’s.

Needless to say all of these advisers have to be paid for (most of them, whether the transaction is completed or not).  

6.  Contingency Arrangements

The documentation for a securitisation is based on ensuring that the loans will be repaid if the borrower fails. To date, only one company which had securitised its borrowings has failed, and the structures which had been created enabled all of the lenders to be repaid in full. However, it does mean that very detailed contingency plans need to be prepared to assure the security trustee that it is able to step in to realise its security if necessary. As a result, very difficult issues may need to be raised with trading partners, suppliers and service providers to assure the security trustee that the operations will continue to function to enable the assets or revenues to be realised in the event of a failure.

Companies only usually start to ask such questions if there is some risk of the possibility of failure, and the mere asking of the question can cause unjustified uncertainty.

7.   Understanding

Complexity and reporting requirements are the true (and heavy) aspects of securitisation, but they can be useful and have positive effects on the business information systems, accounting and management tools of the company. Indeed, undertaking a securitisation can force you to understand and organise better, and in more depth, the business you are doing, the way you are doing it and the risks you are taking. Securitisation can help enhance the information systems and organisation of a company and makes full sense if integrated into the company’s forward strategy. Clearly securitisation can only be used for large volume operations, and repeat deals…….because the economies of scale are large.

 Bankers predict that the growth in securitisation is set to continue, as the awareness of the technique on behalf of borrowers increases. This outline of the disadvantages in this response should enable potential borrowers to make a balanced judgement on this technique.

 October 2000

 For a rosier picture of Securitisations, see  Securitisation – a safe bet for your assets in The September edition of The Treasurer, by Stephen Moller of Simmons and Simmons

April 2007

 

     
 
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