Is A British Court About To Decide The Future Of Securitization?
While momentum chasers in America quarrel over worthless data points and whether some trading desk bought an additional 20 PCs with Intel's brand spanking new i7 CPU to reduce latency by yet another 1 nanosecond, imagine hypothetical green shoots, and storm the futures in hopes of getting other momentum chasers to get behind them, a much more relevant development is currently unfolding which could potentially have a terminal effect on the future of securitization. Creditflux reported last week that the lawyers of bankrupt Lehman Brothers recently filed in English courts a request to overturn the concept of bankruptcy-remoteness for special purpose vehicles (SPVs). If granted, this request could spell the end of securitization as a once-upon-a-time multi-trillion credit product, regardless of how many PPIP or TALF revisions the administration throws into the CRE fire.
According to available reports, and an analysis by CreditSights, Australian investors in a synthetic CDO issued by the Dante Multi Issuer Secured Obligation Program (a Lehman SPV) are attempting to collect the SPV collateral following the bank's bankruptcy.Furthermore, the bank's US lawyers are now suggesting that principle of bankruptcy-remoteness goes against bankruptcy law, arguing that collateral should first pay off in the money swaps before paying off investors. To make things even more complicated, lawyers are now trying to move the case to New York claiming UK courts do not have jurisdiction, because since the swap counterparty is American (even though the documentation is based in England), it should be decided in an American venue. It is odd that the lawyers believe this issue will have i) not only a heightened standing domestically but ii) an increasing probability of success here despite what will likely be vocal opposition by such entities as the CMSA, and by implication, the administration.
Some background info from a recent report by Credit Sights:
The principle of bankruptcy-remoteness of SPVs forms the bedrock of securitization. It is vital to achieve a full separation between the assets and the originator of those assets. One key element of this separation is the so called “true” sale of assets, that ensures that no creditors of the originator have any claims against the sold assets, and those assets cannot be consolidated in the bankruptcy estate in case of insolvency proceedings against the originator. As a result, the transaction can be highly-rated (AAA or AA) even though the originator may have a much lower rating. In funded synthetic transactions, also known generally as credit linked notes (or CLNs), bankruptcy-remoteness of the SPV translates into a claim on the underlying collateral. According to industry standards, the swap counterparty’s claims are subordinated to those of the investors post the counterparty’s default, thus allowing rating agencies to ignore the (usually lower) ratings of the default swap counterparty when assigning a rating to the transaction.
The chart below shows a typical CLN transaction where the swap counterparty is generally a dealer. The issuance proceeds from the investor are used by the SPV to purchase pre-agreed collateral to fund the exposure of the default swap. The SPV simultaneously enters into a default swap with a swap counterparty whereby it sells credit protection in return for an ongoing premium. The collateral coupon and swap premium are then passed on to the investor. The SPV is usually a trust designed to enter into certain limited transactions to enable it to issue debt customized to a specific payout profile or suitable to investors. Each SPV issue is collateralized separately and has recourse only to a defined pool of assets. So while the same SPV can issue any number of notes, no two issues will impact each other. An appointed and independent trustee ensures the interests of all parties to the SPV (the investor and swap counterparty) are considered and maintained. The SPV can be situated in a number of jurisdictions, providing tax benefits. The issued CLN can also be rated and/or listed as required.
It is indeed not an exaggeration that a ruling in favor of the plaintiffs would have major ramifications on securitization. As Credit Sights concludes:
A ruling against the investors would be hugely negative for the credit markets as the concept of bankruptcy-remoteness will most likely not be valid for any transactions where the swap counterparty has a U.S. connection. The immediate outcome will be potential ratings downgrades of funded synthetic transactions, as rating agencies factor in the lower ratings of swap counterparties (provided they have a U.S. connection). In some instances, this could lead to forced unwinds by ratings-sensitive investors, resulting in significant upward pressure on spreads. In the medium to longer-term, this outcome could present a huge hurdle in restarting the securitization market especially as most traditional investors, who are also ratings-sensitive, are unable to participate in the market.
While the case has not generated much traction yet in the legal system, once investors realize the potential ramifications it is likely that this could become the most followed legal development whose adverse repercussions could throw a major wrench in the administration's wheels, which as everyone is aware, are fully focused on doing all that is necessary to not only restart securitization but to bring leverage to the same dizzying heights that brought the system to a grounding halt the first time around.
Data from: Credit Sights.