Securitization as a System of Pooling Resources in the Area of Banking and Finance Law - Essay Example

I. Introduction Securitization as a system of pooling resources adopts different measures to secure transactions. Part of this system is the issuance of asset-backed securities (ABS), which takes the form of bonds backed by financial resources that are not liquid. Non-liquid assets are resources, which could be freely traded in its present form and needs to be converted into another form of instrument for it to be accepted in the capital markets. A popular form of non-liquid asset is the mortgage loans, which could not be readily disposed but may be converted into securities through sale to Special Purpose Vehicles (SPVs) that issue bonds. Conversion of non-liquid assets to tradable securities such as bonds will allow banks to free some capital, which is tied up in the loans portfolio and allows for diversification of financial sources for business operations. Issuance of ABS also allows the originator to remove the non-liquid assets from its books of accounts in cases of true sale transactions, which in effect improves the financial ratio of the originator most especially in cases where it is bound to comply certain risk-based capital standards such as bank reserves. II. Assessment of Risk in ABS As general rule, all the risk connected to the securities traded and purchased is transferred to the buyer. Unlike regularly issued bonds where security is based on the financial soundness of the issuing company, asset-backed bonds depends primarily on the funds or cash flows generated by the pooled assets which makes it less risky than the regular securities. This means that since the securities are backed by specific pool of assets, ABS investors are, to some degree, protected from losing money if the originator of the bonds suddenly goes bankrupt. However, the very nature of ABS would not protect the buyer or investor when the transaction is flawed or vitiated. The degree of the risk involve shall be mitigated or aggravated by the system adopted in the transaction whether it is a true sale or a synthetic securitization. a. True Sale Conventional securitization converts non-liquid assets to marketable securities. “The originator sells a portfolio of receivables to an orphan, non-consolidated SPV which is thinly capitalized bankruptcy-remote conduit.”1 By nature, conventional securitization is funded transaction, which employs a “true sale” system, which transfers the beneficial rights over the securities to the buyer and removes the assets from the books of the originator,2 but still the originator retains a degree of credit risk. This is because the title, which is passed unto the buyer, is merely the title held by the originator, thus, in cases where there are legal impediments to the transfer of title, such will affect the whole transaction. For instance, a legal prohibition in the contract of loan not to transfer the rights over the property may effectively prevent the consummation of the “true sale’ transaction. In case of Linden Gardens Trust Ltd. V. Lenesta Sludge Disposal Ltd. (1993)3, the Court reiterated that there is “no reason for holding the prohibition on assignment as being contrary to public policy” and that such prohibitions in the contract are valid. A “true sale” may also run foul in terms of conflict of laws. Where jurisdiction of the assets backing the bonds is in different countries, laws of these countries may not be the same. Some countries have laws, which do not allow such methods of transfer4. Thus, in instances like these, there could be no valid transfer of rights from the originator to the buyer thereby putting the buyer in equal footing with the other creditors in the event of insolvency. Another risk in “true sales” transaction on the part of the buyer is the possibility of re-characterization when the Court would intervene in the interpretation of the transaction. English case law had evolved rules in re-characterization. In earlier cases such as Welsh Development Agency v Export Finance Co. (1992)5, the basis for the legality of a “true sale” is based on the substance of the agreement and not on the labels put by the parties on the transaction. Later case law however expanded the definition of re-characterization in the case of Smith (Admin. Of Cosslett (Contractors) Ltd. V Bridgend CBC (2003)6, when the Court ruled that reliance on the intent of the parties of contract is not the paramount rule in re-characterization and in the case of Agnew v. Commissioner of Inland Revenue (2001)7 where the Court reiterated that “the question whether it constitute security right is a question of law that is not dependent on the intentions” of the parties. Where public interest is involved, the Court ruled in the case of National Westminster Bank v. Spectrum Plus (2005)8 that it can “override the unrestrained freedom of contract” thus opening the securitization transaction to re-characterization. Where the transaction is re-characterized, it will annul the original agreements of the parties and would put the buyer in the same status with other creditors in the event of insolvency of the originator. b. Synthetic Securitization Unlike in true sale where there is a transfer of beneficial rights from the originator to the SPV, in a synthetic securitization the originator does not sell the portfolio of receivables to the SPV but rather it “borrows” funds by entering into a derivative transaction. Technically, this solves the issues of statutory and contractual bars to the transfer rights in true sales. Furthermore, synthetic securitzation shift the credit risk to the SPV without necessarily transferring the rights thereto. In other words, the SPV assumes the risk over defaults on the securities or receivables backing the bonds. However, to protect itself (the originator) and the buyer (SPV), the SPV can raise funds to cover the cost of the bonds buy trading the asset-backed bonds in the capital markets. Whatever proceeds are generated in the trading of the asset-backed bonds shall be kept as a form security to pay whatever expenses are incur by the bonds such as interest and the likes. the interest on the bonds. Note that whatever interest is due on the bonds shall be paid by the interest earned by the proceeds of the trading of the bonds. In the event of insolvency on the part of the originator, the proceeds of the traded asset-backed bonds shall pay for the liabilities connected to the bonds. On the same vein, in the event of insolvency of the SPV, the protection of the buyer of the bonds shall be the proceeds of the traded asset-backed bonds. Note that whatever proceeds generated in trading the ABS shall be kept in trust or deposited in the bank. As a form of contingency, it should not be touched or used for any other purposes other than to serve as security for the ABS. Another way to secure the SPV’s capability to absorb debtor defaults is by way of over collateralisation where the originator transfers to the SPV a greater amount of assets than the total investor’s funding. The proceeds of the assets in excess of the required collateral shall be kept by the SPV and will be available to the originator at the end of the securitization term to be used as part of the re-purchase funds of the securities. IV. Conclusion Premises considered, my advice to the bank in investing in asset-backed securities will be as follows: 1. Synthetic securitzation would be favourable to the investor bank as the assets absorb the risk on the securities, which serves collateral to the bonds. The fact that the originator will not assume risk over the securities is not a primary setback as assets secures the bonds. The proceeds of these assets will ensure payment on the securities and will ensure payment in the event of insolvency. Furthermore, unlike in a true sale where there are considerations for statutory and contractual prohibitions on the transfer of the rights, securitization does not have there kinds of limitations as there is no purported transfer of securities. Conflict of laws will have minimal effects on synthetic securitization for the same reason that there is transfer o beneficial rights. 2. In the event that the bank will still want to pursue a “true sale” transaction in dealing will the originator, my advice is that it should look into the following matters closely: (a) that the originator has the legal right to transfer the right over the securities and there are no legal impediments thereto, (b) that the assets in question is not subject to conflict of laws in terms of jurisdiction (c) that the sales price is not over-valued to remove it from the ambit of Section 238 of the Insolvency Act 1986 (d) that the contract is not contrary to the interest of the public which will make it subject to re-characterization. Bibliography Books, Articles and Legislations 1. Companies Act 1985 2. Consumer Credit Act 1974 3. Cranston R, (2002) “Principles of Banking Law”, Oxford, Oxford University Press, Second Edition 4. Edwards S. (2004) The Law of Credit Derivatives. JIBL 2004, Nov, 617-655 5. Insolvency Act 1986 6. Trietel G, (2003) “The Law of Contract” London, Sweet and Maxwell, Eleventh Edition Cases 1. Agnew v. Commissioner of Inland Revenue (2001) 2 AC 710 at 31-32 2. In re George Inglefield ltd. (1933) Ch 1 3. Linden Gardens Trust Ltd. V. Lenesta Sludge Disposal Ltd. (1993) 3 W.L.R. 408 [1993] 3 All ER 417 4. National Westminster Bank v Spectrum Plus Ltd (2005) UKHL 41 [2005] 4 All ER 209 at 141 5. Raiffeisen Zentralbank Osterreich AG v Five Star General Trading LLC (2001) EWCA Civ 68; [2001] QB 825 6. Smith (Admin. Of Cosslett (Contractors) Ltd. V Bridgend CBC (2003) AC 336, [2002] 1 All ER 292 at [42] & [53] 7. Welsh Development Agency v Export Finance Co. (1992) BCC 270 Read More