Below is a comment by LSU Professor Joseph Mason and Eric Higgins on the evolving situation in the securitization market. While the folks at the Fed and Treasury pretend that they can breathe life back into the private label securitization market, the legal underpinnings of this OTC market are disintegrating under the weight of mounting losses and falling cash flow. — Chris
Advanta and the Fiction of True-Sale
Joseph R. Mason and Eric J. Higgins†
On Monday, May 11, 2009, Advanta Corp. announced that their credit-card securitization trust would go into early amortization and that they will shut down all of the accounts in the trust. What the casual observer (and most regulators) missed is that this announcement is also endemic of the problems at the heart of securitization: the “true-sale” classification from which securitizations obtain their off-balance sheet treatment.
A company like Advanta issues credit-cards through its banking subsidiary (Advanta Bank). These credit card receivables are then sold into a trust (Advanta Business Card Master Trust). The trust then sells the cash flows from those receivables to investors. This trust is created as a truly-sold bankruptcy remote entity from Advanta Bank and Advanta Corp., allowing Advanta to treat the sale of credit-card receivables as off-balance sheet for regulatory and accounting purposes. Technically, Advanta Corp. has no liability for the assets that are sold into the trust and must not provide any recourse to the assets. This means that if those assets deteriorate in value, it is the problem of the trust investors, not Advanta.
The problem with the arrangement is that it has always been a complete fiction. Such was clearly pointed out in Advanta’s earnings call of April 30, 2009, where management first announced it was concerned about the performance of the credit-card trust. Management stated that they were worried that the trust might go into “early amortization, ” meaning the trust would cease to exist and would immediately begin to pay out all available credit-card receivables to investors in the trust.
Nonetheless, management said that, “… the Company has tools at its disposal which the Company believes will prevent early amortization if used. Management stated that the Company expects to use those tools unless it develops a plan that would better maximize capital and liquidity.” Back up a minute. The trust is supposed to be a separate entity from Advanta Corp. So Advanta is helping to bail out an unrelated entity with investor funds? That doesn’t make sense.
How can Advanta Corp. prevent early amortization without violating “true-sale” accounting? The truth is that they can’t. Providing recourse has historically been taken as implying that the receivables are assets of Advanta Corp. and should appear on their balance sheet. Since providing recourse directly is not allowed, companies like Advanta make statements like those above in order to give the market a sense that there is an implicit recourse guarantee.
Of course, the problem with implicit guarantees is that they are not legally binding. To see this consider Advanta’s May 11, 2009 announcement of the early amortization of their credit-card trust, where Advanta specifically says, “The securitization trust’s notes are obligations of the trust and not of any Advana entity.” What a difference a few days make. On April 30, 2009, management was going to save the securitization trust. On May 11, 2009, management is running away from the trust as fast as they can. Hence, when it is expeditious, firms can ignore true sale provisions and as soon as things get rough true sale provisions protect them.
This problem is not new. A study by Higgins and Mason (Journal of Banking and Finance 2004) looked at recourse provided by credit-card issuers in the mid-1990s. Higgins and Mason found evidence of 17 instances of recourse provided over the 1991-2001 time period that were specifically announced by the parent company. These recourse events helped support 89 separate credit-card securitizations that had a combined value of $35.4 billion.
During the study period, every one of those recourse events violated regulatory rules, but were carried out with a blessing from the regulators despite having recognized the problems of implicit recourse. The OCC published its first warnings on implicit recourse in 1996 and in 2002, the OCC, the Federal Reserve, and the Office of Thrift Supervision issued a joint guidance on implicit recourse in securitizations. The guidance identified specific acts of recourse that would violate true-sale accounting and should force the parent company to recognize the securitized assets on their balance sheet, including specifically the options considered by Advanta.
Since regulators have chosen to ignore implicit recourse, it has become institutionalized industry-wide. In their announcement regarding the downgrading of Advanta’s debt Fitch noted, “…early amortization would occur in the absence of intervention from Advanta within the next month. Intervention could come in the form of charge-off sales, a yield supplement account, or receivable discounting, as seen recently at other large card issuers.” Among those options, receivables discounting is specifically mentioned in the 2002 joint guidance as a prohibited recourse event that would force a parent company to take the securitized assets back on their balance sheets.
Moreover, such a statement means that Fitch – who rates asset-backed securities for a living – admits that they are, in part, basing their ratings on the expectation of implicit recourse being provided even though implicit recourse is : 1) a violation of true sale and 2) not contractually guaranteed.
The problem is that since recourse is not guaranteed, firms can choose to provide recourse when it is expedient and choose not to otherwise. Indeed, that is part of the story of the credit crisis, where mortgage issuers supported pool performance up until roughly mid-2007, when the pools were left to stand on their own. Because securitizations are off-balance sheet, banks can provide that support without holding capital against the activity, ostensibly because they can choose to put the risk to securitized investors if they wish to do so, which no going concern business will ever actually do. Hence, the saying on Wall Street is “the only securitization without recourse is the firm’s last.”
That capital, however, serves as a cushion against declining asset values and provides security to the government’s safety net (deposit insurance). In the run-up to the credit crisis, therefore, banks had too much managed leverage from securitization and not enough capital to provide the recourse that has historically been the sole means of support for troubled assets. As is usually the case, taxpayers are picking up the tab.
The solution is simple. Regulators simply need to enforce their existing rules. If a bank is selling assets with recourse, the bank has to hold capital against those assets as if they are on-balance sheet. Securitization is simple leverage. Securitization allows banks to borrow against their assets and increase their returns. None of this is rocket science. Given the lack of interest, however, it may take a few more failures to get meaningful regulatory changes.