FDIC conference

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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.

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FDIC conference

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1. 3/16/2012 Ken Ayotte 1 FDIC conference Asset Backed Securities: Costs and Benefits of “Bankruptcy Remoteness” Ken Ayotte and Stav Gaon Columbia Business School

2. ABS Transaction Structure

3. 3/16/2012 Ken Ayotte 3 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?

4. 3/16/2012 Ken Ayotte 4 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?

5. Model timeline

6. 3/16/2012 Ken Ayotte 6 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.

7. 3/16/2012 Ken Ayotte 7 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

8. 3/16/2012 Ken Ayotte 8 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)

9. 3/16/2012 Ken Ayotte 9 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.

10. 3/16/2012 Ken Ayotte 10 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 (Arby’s)

11. 3/16/2012 Ken Ayotte 11 ABS with necessary assets: inefficient bargaining in bankruptcy Suppose some assets are necessary to invest in bankruptcy: Ln > 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

12. 3/16/2012 Ken Ayotte 12 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

13. 3/16/2012 Ken Ayotte 13 Effects of secured creditor dilution We assume if lender is secured by collateral worth L, that is senior to DIP lender; d<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

14. 3/16/2012 Ken Ayotte 14 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

15. 3/16/2012 Ken Ayotte 15 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!

16. 3/16/2012 Ken Ayotte 16 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”

17. 3/16/2012 Ken Ayotte 17 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…”

18. 3/16/2012 Ken Ayotte 18 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

19. 3/16/2012 Ken Ayotte 19 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

21. 3/16/2012 Ken Ayotte 21 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

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