Securitization is a financial tool which consists in the issuance of securities backed by assets put together in a "pool", which assets generate future cashflows. Generally, the "pool" of assets takes the form of an estate independent from the entity generating those assets (i.e., the company seeking the financing, or one of its affiliates), which is known as the "originator", by means of a transfer into a "vehicle" (an entity separate from the originator). The transfer can be done in the form of a sale of assets to a special purpose company or closed-end mutual fund, or as a fiduciary assignment to a trust created for this purpose. After this, the vehicle issues the securities in most of the cases, and interest on and amortization of the securities are satisfied with the cashflows generated by the underlying assets.
The securitization of assets generates a series of advantages as a financial tool, both for the company that obtains funds through this system and for the investing public. From the company’s point of view, there is a distinction between on-balance sheet and off-balance sheet securitizations. In the case of on-balance sheet securitizations, the originator assumes the role of issuer of the securities, and the effect is that the underlying assets are not completely isolated from the rest of the originator’s estate. The scope of the securitization is limited to allocating certain assets to guarantee the payment of the obligations originated by the issuance. Therefore, the securities so issued are only debt instruments backed by assets, which are known asset-backed bonds.
In this case, the repayment of the debt comes out of the issuer’s general income (i.e. the underlying assets are not the only source of repayment) and therefore these assets are not completely isolated from the claims of other creditors of the issuer, although the holders of the asset-backed bonds may have a certain priority over them. For this reason, the issuance must be reinforced with additional guarantees, and the issuer is obligated to maintain a constant value for these guarantees during the life of the securities. Another option within on-balance sheet securitizations is for the bonds to be repaid exclusively with the cashflows originated by the underlying assets, but the assets are still the originator’s property and the issuance results in debt of the originator (pay through system).
It is, however, in the case of off-balance sheet securitizations when the benefits of this financial tool are more fully accomplished, in which is known as the pass through system. Those benefits are, among others:
- The transaction does not result in debt for the company. Once transferred to the vehicle, the assets are no longer the property of the originator. In this manner, the ability for the company to incur debt in the future is not affected, financial ratios are improved or maintained, and the company avoids the breach of covenants assumed under other financial agreements in force.
- At a macroeconomic level, securitizations represent a better and more efficient distribution of the risk appetite and the need for cashflows in the economy. Thus, a company that possess assets capable of generating cashflows in the future, but is under an immediate need for funds, can transfer the receivables to investors willing to invest their capital over time.
- New possibilities for diversification of investment appear, the aggregate investment supply grows and, in general, financial costs in the economy decrease. The general public gains access to investment opportunities in industries and activities otherwise out of reach.
- Liquidity is improved for assets that were not easily traded or transferable, or that were only traded or transferable at high transactional or financial costs.
- Lower financial costs are obtained through the isolation of assets from the estate of the person seeking finance, provided the assignment is legally perfected and the repayment is properly guaranteed (in general, through overcollateralization, letters of credit or other banking or third party guarantees). The financial cost for the company is reflected on the discount over the face value of the assets transferred to the trust.
- In the case of international securitizations, exchange rate risk, convertibility risk, political risk and others, are minimized through two mechanisms: (i) in many cases the receivables generate cashflows coming from abroad (e.g. exports), which are transferred to the trust without being converted into local currency, and (ii) the vehicle that issues the securities is a foreign entity, located out of the boundaries of the originator’s country and subject to foreign law and jurisdiction. Moreover, in some cases the rating given to securitizations of this kind is higher than the sovereign debt rating of the originator’s country. This obviously has a direct beneficial impact on the financial cost.
- The investing public receives an attractive and relatively simple financial instrument, without the credit risk inherent to the originator.
Assets to be pooled in a securitization must have certain characteristics that make them suitable for this type of transaction. The viability of the securitization will depend on the features of the receivables acting as underlying assets, among others: type of transaction originating the credit, supporting documentation, characteristics of the debtor, yield, time to maturity, etc., apart from some aspects concerning the originator such as size, industry, market share and others. The risk inherent to the underlying assets is one of the main factors in determining the price of the securities being issued, and in certain cases such risk needs to be lowered through additional guarantee mechanisms, as described further down in this paper. In general, the underlying assets must have uniform characteristics as to type, origin, documentation and future management. The ideal characteristics are the following:
- a uniform portfolio of assets;
- clear configuration of the receivables;
- well defined payment patterns;
- cashflows mathematically and statistically predictable;
- low levels of delinquency or default;
- total amortization by maturity date;
- several debtors (which allows a reduction of risks by diversification);
- high liquidity (although one of the very objectives of the securitization is to increase liquidity);
- higher return than the securities being issued; and
All of these ideal characteristics may not be present in every case, and their stronger or weaker presence will to a great extent determine the particular structure required for the securitization.
On certain occasions, the underlying assets are not enough to back the issue of the securities and additional guarantees are needed to make the investment more attractive, reduce the risk and obtain better rates for the originator. This is done by "internal" and "external" mechanisms of credit enhancement. Among the internal credit enhancement mechanisms we may find the following:
- overcollateralization: the value of the underlying assets exceeds by a certain percentage the principal amount of the securities issued, as a way to cover for delinquency or default of the debtors;
- subordination: the securities are divided into two or more categories, with different levels of priority of payment. The securities with the higher priority are placed among investors that do no want to run risks, and the subordinated ones among investors that in exchange for a bigger return assume the risk of not being paid should the cashflows from the underlying assets be insufficient. Sometimes the subordinated securities are acquired by the originator, in which may be viewed as an overcollateralization mechanism, since the preferred securities have a right to be satisfied with the flows generated by the whole of the trust’s assets even when they represent only a part of this total;
- excess cash flow or "spread account": the cashflows originated by the underlying receivables (i.e. interest from loans) exceed the amounts needed for the service of the securities issued by the trust. In other words, there is an excess of the underlying assets’ yield over the interest rate payable to the investors, which excess is used to fund a guarantee account;
- replacement of assets: a mechanism is provided for replacement of those receivables whose collection risk increases during the life of the securities, in accordance with predetermined patterns.
On the other hand, the "external" credit enhancement mechanisms can be letters of credit issued by banks or other entities, insurance policies that cover certain levels of debt collection, collateral and other guarantees from the originator or third parties, or credit lines available to cover for shortages of funds for payment to the investors.
The quantity, amount and type of the additional guarantees needed will depend on the quality of the underlying assets. As to this respect, the intervention of the rating agencies is essential; they will determine the amount and type of guarantees needed to obtain the required credit rating. However, the additional guarantee mechanisms are useful only up to the point when they make the securitization become too expensive compared to other financing alternatives.
In Argentina, securitizations are accomplished through "financial trusts", a sub-species of the general trust regulated by Law N°24,441 (the "Trust Law") which introduced this institution into the Argentine legal system in 1995. Additionally, financial trusts are governed by the Regulations of the National Securities Commission (Comisión Nacional de Valores, or "CNV") and the Regulations of the Argentine Central Bank (Banco Central de la República Argentina, or "BCRA") when the underlying assets consist of receivables originated by financial entities subject to the regulation and supervision of the BCRA. Up to date, an important number of financial trusts have been established as effective financing instruments for companies and other entities (such as provincial and municipal governments).
The Trust Law defines the financial trust as the one whose beneficiaries are the holders of securities guaranteed by the assets transferred in trust. Only financial entities under surveillance of the BCRA and other entities specially authorized by the CNV may act as financial trustees.
Securities issued by financial trusts adopt the form of debt instruments or participation certificates. The debt instruments may be issued by the trustee, the trustor or a third party. However, the most common procedure is for the trustee to act as the issuing entity. Certificates of participation can only be issued by the trustee and normally besides entitling the holder thereof to a fixed or variable income, have attached distribution rights over any assets remaining after liquidation of the trust.
In general, for security and practical reasons, securities publicly offered by financial trusts are issued in book entry form, with Caja de Valores S.A. (the central entity for registration, transfer and clearing of securities in Argentina) acting as registrar and paying agent. Caja de Valores has entered into agreements with Euroclear and Clearstream, and through these systems it maintains links with the Depositary Trust Company (DTC) in New York, all of which facilitates international transfers and settlement of the securities and allows issues to be placed simultaneously in Argentina and in Europe and the United States.
In order to be publicly offered in Argentina, securities issued by financial trusts must obtain a public offering authorization from the CNV. These securities may also be listed on the Buenos Aires Stock Exchange, the Open Electronic Market (Mercado Abierto Electrónico, or MAE) and other securities markets of the country. For this purpose, a prospectus must be prepared by the issuing entity and submitted to the CNV as part of the public offering authorization process. After being approved by the CNV and after publication in the bulletin of the Buenos Aires Stock Exchange, the prospectus may be distributed to the investors. Nevertheless, before final approval by the CNV is obtained, a preliminary prospectus may be distributed during previous contacts with potential investors (road shows or other kind of meetings).
Securities issued by financial trusts are among the assets authorized to be acquired by the Argentine Pension Funds Administrators ("AFJPs"). During the last years, AFJPs have become a very important source of financing due to the growing mass of funds under their administration, which as of August 2001 amounted to over twenty one billion dollars. It should be taken into consideration that in case that acquisition by AFJPs is contemplated, the issue must be rated by rating agencies authorized by the CNV and the BCRA.
The Trust Law provides for total separation of the trust’s assets, which become an estate independent from the trustor and the trustee. The trust’s assets are therefore beyond the reach of the creditors of the trustee and the trustor, either by individual or collective action (i.e., bankruptcy proceedings), with the only exception of fraudulent transfers. The risks associated with the originator’s bankruptcy are in is this way greatly reduced, and only subsist to the extent the originator keeps acting as collection agent for the trust. In this case, the risk is represented by amounts collected by the trustor/collection agent, until it transfers them to the trust. Nevertheless, this risk can be practically eliminated by (i) obligating the trustor/collection agent to transfer collections to the trust within a short period and (ii) creating a guarantee (reserve account) for the average amount of collections for the time they are in the hands of the trustor. Thus, for example, if there is an obligation of the trustor as collection agent to transfer collections every fifteen days, and it is estimated that the average collection in those fifteen days is, let’s say U$S 20,000, a reserve for this amount (plus an extra amount for the time required to substitute the trustor as collecting agent) is constituted at the outset of the trust (the reserve can be discounted from the asset acquisition price), to cover for the eventual lack of transfer due to the trustor’s insolvency. If this insolvency occurs, the lack of transfer is covered with the guarantee, the collection agency agreement is terminated and a new collection agent is appointed.
Once the securities are placed, the trustee (or the corresponding issuing entity) is subject to the reporting obligations stated in the Regulations of the CNV. This system provides for delivery to the CNV and to the relevant Stock Exchange of financial information about the trust in a periodical manner and for immediate communication of any material developments. Moreover, this information must be disclosed to investors through publication in the news bulletin of the Stock Exchange or other mechanisms provided for in the trust agreement. On the other hand, those trusts whose assets are receivables originated by financial entities are subject to the control, reporting obligations and surveillance of the BCRA.
Transactions relating to the issuance, placement and transfer of publicly offered securities issued by financial trusts enjoy a favorable taxation treatment, provided they comply with certain requirements established in the pertinent laws and regulations. However, for purposes of determining the applicable taxation treatment in each particular case, the structure must be carefully analyzed taking into account, among other aspects: (i) the type of assets to be securitized, (ii) who the potential investors in the securities will be (for example, whether they are Argentine or foreign residents, individuals or entities), (iii) nationality of the issuer, (iv) term of the trust, and (v) underlying assets investment plan.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.