Carolyn Sissoko left me a highly thought provoking comment recently. She referenced a paper by Kenneth Kettering, Securitization and Its Discontents, that is definitely worth reading. Both Carolyn and Ken’s arguments are multi-faceted, and today I want to concentrate on one of them – the problem of identifying a fraudulent conveyance.
First, why do we care? Roughly, because if a transaction is judged to be one, it can be invalidated in bankruptcy. The buyer can be deprived of something that they might have thought that they had title to.
The foundation of the law here is ancient: a statute from Elizabeth I’s reign (13 Elizabeth 1571) according to Kettering. The idea, though, is simple: a transaction will be judged fraudulent if it was made with actual intent to hinder, delay or defraud any creditor. Thus for instance if on my bankruptcy some of my assets are transferred to you with consideration less than their fair value, then the conveyance is fraudulent and unlikely to be upheld by the bankruptcy judge.
There are many other issues in this space, and the issue is complex, so I am going to simplify down to just this one aspect of fraudulent conveyance and its impact on securitisation, because that is more than enough for one post.
Note that in order for there to be a fraudulent conveyance, there needs to be a conveyance; so any structure where the asset is not sold is not at risk (although obviously any other form of risk transfer might be). Thus for instance covered bonds are not a problem as (typically) the assets stay on balance sheet, and explicit statutory protection gives the bond holder security*.
The problem in cash securitisation is that consideration is often in several parts: I sell assets but keep junior tranches of the deal. Therefore if the assets turn out well, I am paid via excess return on the collateral pool going to the equity tranches. This often means that I can be unconcerned about a little over-collateralisation as, economically, it will come right in the end. Getting to the end though involves not going bankrupt, and that o/c meanwhile sails close to that badge of the fraudulent conveyance, selling something for less than it is worth†.
Now, I don’t take the position that securitisation ‘doesn’t work’ for these reasons: clearly in some operational sense it does work. But these considerations show that the interaction of ancient law and modern finance can generate friction and – occasionally – unexpected case law. (LTV Steel, a case that shook the entire securitisation industry, is a good example.) The risks are often greatest when one is pushing the edge of established structures and, perhaps unwittingly, crossing a line drawn hundreds of years ago and never re-drawn.
*Although see here for the rather less satisfactory situation in the US.
†The rules of article 9 of the UFCA are some help here, as they remove some of the risk of o/c.