Risk Retention and Rent Seeking: A Hidden Cost Resulting from the. Securities and Exchange Commission s Proposed Rules

Transcription

1 Risk Retention and Rent Seeking: A Hidden Cost Resulting from the Securities and Exchange Commission s Proposed Rules When the Dodd-Frank Act s risk retention rules for securitizers goes into effect, the originators of loans who use a horizontal risk retention strategy will be extracting rents from the note holders in the capital structure of the vehicle on account of the vehicle s inability to file for bankruptcy. Moreover, the risk retention rules will do nothing to eliminate the incentive of originators to keep the size of equity tranches to the bare minimum, as this incentive arises from the bankruptcy remoteness of the securitization vehicles. The literature on bankruptcy remoteness in the context of securitization often notes that the purpose of bankruptcy remoteness is to isolate the asset pool from the strong arm of any trustee in bankruptcy of the originator or to mitigate the risk that the vehicle will be substantively consolidated with the originator by a bankruptcy court. 1 This adds value by decreasing the risk that note holders will have their positions reduced in the event of the originators bankruptcy, thus isolating the asset pool from a material, exogenous risk factor. Most practice literature on the subject limit the discussion of the purpose of bankruptcy remoteness to this benefit. 2 Lurking in the shadows of this benefit, however, is a cost, imposed upon the note holders in the capital structure by the originator. Among other steps taken to make the securitization vehicle bankruptcy remote that are beyond the scope of this paper, the originator will insert provisions that effectively make it impossible for the vehicle to file a 1 See PRACTICAL LAW COMPANY, Practice Note, Securitization: The SPV, #a (noting the purpose of bankruptcy remoteness is to ringfence, or isolate the asset pool from (subscription required). 2 See, e.g., id.; CROWELL MORING, Financial Services Alert, Caution: Bankruptcy-Remote Entities Are Not Necessarily Bankruptcy Proof (April 25, 2012), Alert/Caution-Bankruptcy-Remote-Entities-Are-Not-Necessarily-Bankruptcy-Proof (last visited Feb. 20, 2013).

2 voluntary petition for bankruptcy relief at all. This paper will show that such provisions actually impose costs onto note holders by removing access to bankruptcy relief. This paper will proceed as follows. First, it will outline the notion of bankruptcy costs of debt and introduce the risk mitigating benefits of securitization vehicles. It will follow by showing how the elimination of access to bankruptcy benefits for the securitization vehicle imposes costs on the note holders. By removing bankruptcy costs, the securitization vehicle need not balance expected bankruptcy costs against the benefits of tax shields in the determination of the ideal capital structure, eliminating a key factor that mitigates the risk of an unsustainable amount of debt, which has the effect of shifting default risk to the note holders. If the risk retention rules proposed by the federal banking agencies become final, originators will also receive the benefit of additional tax shields. Bankruptcy Costs of Debt In the analysis of corporate capital structure, chief financial officers operate under a presumption that there is an ideal ratio of debt to equity. 3 They determine this ratio by balancing the benefits derived from tax shields of debt the value added to a companies net income on account of the deductibility of interest payments on debt before tax assessment and the expected bankruptcy costs that increasing debt has on the company, 4 which result from the direct correlation of insolvency risk and increased debt. 5 Bankruptcy costs are from two sources: (1) direct, those costs directly associated with filing for and administering a bankruptcy and (2) indirect, those costs that result from being in bankruptcy, for example, lost sales or consumer confidence in the companies 3 See Jerold B. Warner, Bankruptcy Costs: Some Evidence, 32 J. FINANCE 337, 337 (1977). 4 Bankruptcy costs are always expected, as the exact probability of bankruptcy cannot be known ex ante. See Jerold B. Warner, Bankruptcy Costs: Some Evidence, 32 J. FINANCE 337, 345 (1977). 5 Id., at 337.

3 brand. For every company, there is an ideal debt to equity ratio that balances these forces. 6 Indirect bankruptcy costs may arise before or even in the absence of bankruptcy, if the customers of a distressed company perceive default to be likely. 7 For our purposes, indirect bankruptcy costs are an extremely important consideration, as in the presence of the 2008 macroeconomic shocks we saw a flight from the notes issued by securitization vehicles, notwithstanding that the vehicle effectively were unable file due to their bankruptcy remoteness. 8 The massive unloading of such positions likely contributed to extreme downward pressure on the prices of such securities. 9 Securitization Establishing a securitization vehicle and selling assets in exchange for cash, which is financed through the issuing of notes by the vehicle to investors, transforms assets whose value derives from future cash flows, such as mortgage loans, into cash now for the company. Securitized asset pools provide, generally, lower risk than the note holder would be exposed to if, for instance, it bought a participation interest in a single asset or asset class on the balance sheet of the company. The risk is lowered in a few main ways. Firstly, the asset pool is generally diversified by a number of factors including geographical location of the borrowers of the underlying debt and the risk profiles of the 6 Id., at Jerold B. Warner, Bankruptcy Costs: Some Evidence, 32 J. FINANCE 337, (1977). 8 See Caroline Salas, Ex-Marathon Manager Starts Hedge Fund to Buy Distressed CDOs, BLOOMBERG.COM (Feb. 14, 2008), (reporting on the creation of the hedge fund, Hildene Capital, to buy the distressed positions of pre-financial crisis investors who needed to unload their risk). 9 See CREDIT FLUX, The Year CDOs Fell Off the Cliff, Jan Newsletter, (noting that CDOs accounted for over $500 billion in losses up to the date of the newsletter) (subscription required); Cf. CREDIT FLUX, Demand Drives up CLO Equity Prices, March 2010 Newsletter, (applying simple supply and demand analysis to explain price increase in equity tranches of collateralized loan obligations) (subscription required).

4 borrowers. 10 Secondly, the asset pool is sliced into tranches, which are typically assigned descending priorities in cash flow rights with the first in line receiving the first payments (and, correspondingly, the lowest return). 11 Lastly, originators may attach credit enhancing mechanisms to tranches, such as credit default swaps, to further mitigate risk. 12 In addition, another factor that reduces risk is the bankruptcy remoteness of the securitization vehicle. Through a web of legal mechanisms, the originator of the securitization will isolate the note-issuing vehicle so that the assets transferred to the vehicle are protected from the strong arms of any trustee in bankruptcy, neutralizing the risk of assets within the asset pool being clawed back into the estate of the originator for distribution to its claims holders. 13 For our purposes, the key action taken by the originator is the effective removal of access to bankruptcy benefits for the securitization vehicle. This allows for the originator to exclude the assets transferred to the pool from its balance sheet, which eliminates its default risk and thus lowers any necessary capital requirements that must be held to offset the risk imposed by the asset. The central question of this paper is whether this adds (or, at least, does not destroy) value from the perspective of the note holders. To the extent that it does not add value or does destroy value by imposing risks on the note holders and the note holders are not adequately compensated for this, the originator is extracting rents 10 See John S. Robins, David E. Wallace, & Mark Franke, Mezzanine Finance and Preferred Equity Investments in Commercial Real Estate, 1 MICH. J. PRIV. EQUITY & VENTURE CAP. L. 93, (2012) (internal citations omitted). 11 See Id., at See FIN. CRISIS INQUIRY COMM N, 112 TH CONG., THE FIN. CRISIS INQUIRY REP. 144 (Comm n print 2011) available at (last visited Apr. 26, 2011) (graphic showing example CDO structure)[hereinafter FCIC Report]. 13 See Mark Carey & Rene M. Stulz eds., Gary B. Gorton & Nicholas S. Souleles (authors)special Purpose Vehicles and Securitization in RISKS OF FINANCIAL INSTITUTIONS 553(2007) (noting that in the event that a securitization vehicle is not bankruptcy-remote, a trustee in bankruptcy could claw back the assets of the vehicle into the bankruptcy estate of the originator).

5 from the note holders. With the addition of the risk retention rules under Dodd-Frank, the rents extracted on account of this will increase. Absence of Bankruptcy Costs as Extracting Rents Due to the vehicle s effective inability to file bankruptcy, there are no offsetting bankruptcy costs of the debt it has issued to the note holders. Therefore, the holder of the equity tranches that receive the residual cash flow rights of the securitization vehicle obtain the tax shields from the issued debt above them in the capital structure of the vehicle with no offsetting expected bankruptcy costs. No cause for alarm necessarily arises from this: for an equity tranche holder separate and independent of the originator, this might be a requisite benefit to convince it to take the position. But to the extent that the equity tranche is held by the originator, it receives the additional benefit, beyond access to liquidity, of the tax shields. Before 2008, the equity tranches of securitizations would typically be held by hedge funds. 14 Additionally, the equity tranches were very small. 15 After the financial crisis, however, Dodd-Frank requires originators to retain at least some credit risk in the assets it sells to the securitization vehicle, which can be accomplished by holding positions in the equity tranche so-called horizontal risk retention. 16 The notion here is that by 14 See FCIC Report, at 192 (noting that, of the collateralized debt obligations issued in the second half of 2006, over half of the equity tranches within them were held by hedge funds). 15 See Taylor A. Begley & Amiyatosh Purnanandam, Design of Financial Securities: Empirical Evidence from Private- Label RMBS Deals at 43 (2012) (working paper), available at (noting that in a specimen residential mortgage backed security that the equity tranche constituted only a 0.90% interest in the whole vehicle). 16 See Federal Banking Agencies Proposed Rules, Credit Risk Retention, 13-14, (noting that, in enacting the Dodd-Frank Act, legislators made clear in legislative history that when securitizers retain credit risk, their economic incentives are aligned better to those of the note holders). To fix this moral hazard problem, Dodd-Frank requires securitizers to retain credit risk. 15 U.S.C 15 U.S.C. 78o-11 (c) (2011) (requiring the Federal banking agencies to create rules to require any securitizer to retain not less than 5% of the credit risk for any asset transferred into an asset backed security). A permissible form of retaining such risk under the proposed rules is horizontal risk retention, which is maintaining the first loss position in the securitization pool. Federal Banking Agencies Proposed Rules, Credit Risk Retention, at 23.

6 requiring the parties behind the transaction to retain risk, they will have incentives to monitor the quality of the assets in the pool. 17 The agencies promulgating these rules considered that the securitization vehicle may impose independent risk on the investors in the notes issued. The current definition in the proposed rules for credit risk includes non-payment, insolvency, and bankruptcy risks of the issuing entity, which is the securitization vehicle. 18 Under Dodd-Frank, the equity tranche will be held to a certain extent by the originators insofar as they utilize the horizontal strategy for risk retention. Therefore, the absence of bankruptcy costs will redound to the benefit of the originator. If the logical compliment to no bankruptcy costs no access to bankruptcy imposes costs on the note holders without adequate compensation, the originator will be extracting rents from the note holders. In response to the proposing agencies solicitation of comments, some market participants urged that the agencies not include these risks insofar as they are unrelated to the underlying assets in the asset pool in order to preserve the bankruptcy-remote status of and accounting treatment for securitization to preserve the financial advantages of the product and promote the orderly flow of credit. 19 This paper does not argue otherwise. It only argues that, to the extent that the underlying assets result in the securitization vehicle s inability to service its debt when such service is due, this imposes a real risk on the note holders that should be incorporated into the price or should be 17 See Federal Banking Agencies Proposed Rules, Credit Risk Retention, 13-14, (noting that, in enacting the Dodd-Frank Act, legislators made clear in legislative history that when securitizers retain credit risk, their economic incentives are aligned better to those of the note holders). 18 Proposed Rules at Blackrock comment at 8, available at see also PHH Comment at 18, available at (noting that clearly defined administrative instructions provided to the trustee and other agents involved in the securitization ensure that such administration is independent of the issuing entity and, therefore, that it is inappropriate to consider such risks).

7 contemplated in the governing documents of the vehicle and the indenture to ensure the note holders have access to adequate remedial solutions. 20 The securitization vehicles typically are thinly capitalized. 21 The bankruptcy costs of debt normally provide a check on managers to ensure that there is sufficient capital to absorb such costs. 22 While there are many factors leading up to the financial crisis that led originators not to hold large equity positions in the securitization pools they created, a possible one that has received no attention is the absence of bankruptcy costs of debt in the securitization vehicle. Absent such costs, this adds another factor that limits to incentives for originators to provide more equity in the capital structure of the vehicle. For every dollar that the equity decreases, that is one dollar of default risk shifted to the note holders. 23 This also reduces any bankruptcy premium that investors in the notes might try to extract from the market, thus decreasing the cost of debt associated with the notes. 24 The 20 One goal of special purpose vehicles is often to isolate the credit risk of the assets underlying any secured financing from the exogenous risks of any parent or affiliate of the vehicle so that the creditor can evaluate the risk of nonpayment, insolvency, and bankruptcy of the vehicle independent of any related entities. See William McInerney, From Bankruptcy-Remote to Risk Remote: Reframing the Single-Purpose Entity in CMBS Finance, N.Y. LAW J., Aug. 23, 2010, available at (noting that isolating the vehicle in the context of real estate finance allows for the lender to evaluate the risk of non-payment only as it relates to the underlying mortgage asset it issues at the vehicle level). This paper advocates nothing different, just that the risks might be more varied or numerous than previously thought. 21 See Mark Carey & Rene M. Stulz eds., Gary B. Gorton & Nicholas S. Souleles (authors)special Purpose Vehicles and Securitization in RISKS OF FINANCIAL INSTITUTIONS 550(2007). For an example of the thin equity tranches in collateralized debt obligations, see MJX ASSET MANAGEMENT, Investment Vehicles, (last visited Feb. 20, 2013). 22 See Barry E. Adler & Larry E. Ribstein, Debt, Leveraged Buyouts, and Corporate Governance, Cato Policy Analysis No. 120 (May 2, 1989), (noting that, in the context of leveraged buyouts, which maintain high debt to equity ratios, one can expect the specter of bankruptcy to mitigate, at least to some degree, the thinness of the capitalization of the company). 23 See Federal Banking Agencies Proposed Rules, Credit Risk Retention, 13-14, (noting that, in enacting the Dodd-Frank Act, legislators made clear in legislative history that when securitizers retain credit risk, their economic incentives are aligned better to those of the note holders). To fix this moral hazard problem, Dodd-Frank requires securitizers to retain credit risk. 15 U.S.C 15 U.S.C. 78o-11 (c) (2011) (requiring the Federal banking agencies to create rules to require any securitizer to retain not less than 5% of the credit risk for any asset transferred into an asset backed security). A permissible form of retaining such risk under the proposed rules is horizontal risk retention, which is maintaining the first loss position in the securitization pool. Federal Banking Agencies Proposed Rules, Credit Risk Retention, at Mark Carey & Rene M. Stulz eds., Gary B. Gorton & Nicholas S. Souleles (authors)special Purpose Vehicles and Securitization in RISKS OF FINANCIAL INSTITUTIONS 552(2007).

8 negative implication is also true, the equity tranche holders in the vehicle then extract rents from the note holders above them in the capital structure. While it might be argued that, if these rents were high enough, then the note holders would require compensation for them. 25 But information asymmetry with respect to the quality of the asset pool (and the market reliance on what turned out to be poor third party checks on this quality), arguably prevented note holders from realizing that this increase in value redounding to the benefit of the equity tranche holders was occurring. 26 This is true because the note holders, especially senior note holders, did not think it was possible for their position to be jeopardized. The upper tranches of these securitizations were investment grade or better. Therefore, note holders might have presumed (perhaps unreasonably) that the risk of default was that of one of our country s perennial corporations or, in the case of AAA rated tranches, treasury securities. Conclusion Even absent the risk retention rules, bankruptcy remoteness shifting risk to the note holders that inures to the benefit of the holders of the equity tranche. While investors presumed that diversification, tranching, and credit enhancements would protect them from such default risk, we saw in 2008, that is not always the case. While times were good, equity tranche holders enjoyed the benefit of tax shields. When things went bad, the note holders were often wiped out. The risk retention rules may have the positive effect of aligning incentives between originators and investors, but they would also have the effect of granting 25 See Ward Farnsworth, THE LEGAL ANALYST 75 (2007)(noting that, in a dispute among two parties, the party who values the state of the world the most will pay his adversary to maintain it to his liking). 26 See Taylor A. Begley & Amiyatosh Purnanandam, Design of Financial Securities: Empirical Evidence from Private- Label RMBS Deals at 9 (2012) (working paper), available at (noting that informational asymmetries give rise to adverse selection problem).

9 originators a greater tax shield. The removal of bankruptcy costs of debt creates a clear gain in value for the originator via shifting default risk to the note holders. While this default risk shifting will decrease with the credit risk retention requirements under the proposed rules, the originators receive the additional benefits of tax shields by virtue of holding positions in the equity tranche. Absent bankruptcy costs, originators will have incentives to limit their position in the equity tranches and the size of equity tranches in general in order to continue to shifting default risk onto the note holder.