Ten Easy Ways to Make a Loan Nonsecuritizable

All-purpose argument when negotiating traditional loan documents: "Our opinion committee will never go for this."

All-purpose argument when negotiating loan documents in the brave new world of securitized loans: "The rating agency will never go for this."

A. What's Different About Securitization?

If you really understand securitization, you can skip this section. But who really does? Most of the mistakes we've seen in loan origination come from not paying enough attention to the fundamental differences between securitized pooling and traditional lending practices.

Securitization is a method of obtaining investment capital by packaging a group of similar financial assets, such as mortgage loans, and then selling interests in the entire pool to investors in the capital markets. This approach gives borrowers access to a wider range of funding sources with different economic goals and, usually, lower overhead costs than traditional lending institutions such as banks and insurance companies.

Securitization of loans brings new money into the lending market by making it possible for groups of investors to aggregate their loan funds to buy larger pools of more diverse obligations. If one thousand lenders each make one consumer loan, some percentage will risk a complete loss due to default or documentation flaws. By pooling their funds and the investments together, and buying fractional 1/1000th shares in the entire loan portfolio, the lenders diversify their investment and spread their risks of loss. The "arrangers" who assemble and resell the portfolios have carved out their own rewarding financial niche. The development of more sophisticated data-handling capabilities and loss-prediction models have permitted arrangers to pool and predict the aggregate return from portfolios of commercial loans (and other pooled assets) more accurately. This also contributes to more efficient pricing.

At the same time, liberalization of the securities laws and banking regulation have expanded the eligibility rules for persons investing in such securities, and decreased the cost and delay associated with offering those investments. The legal structuring technologies to create "special purpose vehicles" and "bankruptcy-remote vehicles," discussed below, have been developing for approximately fifteen years, and are being refined by case law and adopted in an ever-widening range of transactions. Encouraged by the savings in administration costs, and the increased access to the capital markets as a relatively low-cost source of funds, lenders have gradually applied this technique to more diverse pools of unique financial assets. An increasing variety of financial assets are being packaged by securitization methods, including, notoriously, a bellwether offering of "Bowie Bonds" from David Bowie's stream of future record royalties.

1. Differing Economic and Regulatory Environments

The different requirements for securitizable loans derive mostly from the different needs and economic roles of the ultimate investors on whom a lender will lay off his risks. Traditional lenders think, which other banks or mutual funds will buy participations in this, and after closing, can I get it past the regulators in our next audit? Originators think, will this fit within the criteria for the next pool we're selling off, and can I get it past the rating agency before closing?

A traditional lender lends money from its own balance sheet. Banks, for example, deploy funds generated from repayments of other loans, consumer deposits and the like; insurance companies use funds generated from the policies they sell. It follows that a traditional lender focuses more on holding a loan. Its primary concern is applying its own credit criteria: to verify that borrowers and their collateral meet certain quality standards, and are likely to pay the borrowed money back.

A securitizing lender, on the other hand, goes out into the capital markets to get someone else's money to lend to the borrower. Once a loan is originated, this newer breed of lender "pools" or bundles it with other similar loans, and transfers it to an arranger, such as an investment bank's mortgage capital desk, which sells the income generated by the pool off in pieces to investors in the capital markets. The term "securitization" refers to the conversion of the pool of loans into securities, by re-dividing the income from the pooled loans into new (and usually more abstract) securities, which are then sold to the investors. The securitizing lender is a seller, with the primary goal of conforming loans to criteria optimized for resale to investors.

Of course, the "hold" and "sell" models are two points on a continuum, not absolute rules. Conventional lenders do not always hold the loans they originate. Even when they do, their internal credit criteria are heavily influenced by outsiders such as regulators and equity investors, as well as third parties on whom they may wish to lay off some credit risk, such as mortgage insurers and loan participants. Similarly, securitized lenders may not always be able to sell. Most securitization deals leave some credit risk with the originator (through representations, warranties and repurchase obligations) for loans that default or do not perform as expected. Bad loans may therefore end up back on the originator's balance sheet. In addition, some lenders initially retain part of the risks of the loans they originate, by holding onto a "B" repayment tranche with inferior or residual payment rights.

Nevertheless, the hold-versus-sell distinction helps explain the variations in documentation, structure and risk-taking behavior that distinguish the new world of securitized lending from the old world of conventional loans. The imperative that each loan must be pooled and sold off into a specific capital market, with different regulatory requirements and different investors than conventional lenders face, pulls with an irresistible force on everything that a securitizing lender does.

Deconstructing "lenders". Securitization unbundles the traditional lender role into separate parts an "originator" that finds the borrower and does the credit analysis, a separate "sponsor" or "arranger" that finds the investors and structures the pooled assets into securities, and "investors" that supply the funds by purchasing the securities. The pool is generally owned by a trustee or other investors' representative who in turn distributes periodic payments to the investors. Yet another party, the "servicer," generally assumes the traditional lender's role remaining after the loan has been closed and funded. There are often two servicers designated - one for operations in the ordinary course of business, and the other to service the loan only after a borrower default. There are several different variations of the lender structure outlined above, as the precise structure of any transaction depends largely upon the needs of the transaction and the preferences of the arranger, and is also informed by the desire for a particular tax or accounting treatment (matters beyond the scope of this article).

Cost of funds. As one might expect, the pricing of securitized loans tends to be significantly lower than that of traditional loans. For one thing, the capital markets are large and efficient, which results in more price competition than the oligopoly of traditional institutional lending. For another, investors in securitized pools are not subject to the substantial reserves, capital adequacy regulations and regulatory compliance costs which are imposed on most traditional lenders (as mentioned earlier). In practice, the savings from these two differences is often great enough that securitizing lenders can underbid traditional lenders. Thus far, except for occasional hiccups in the capital markets, this has generally been true even after factoring in the higher transactional overhead associated with more complicated documentation, securities law compliance and significant fee income to the sponsors and servicers.

Regulatory pressures. As noted above, in return for their unique access to consumer funds and certain governmental liquidity sources, traditional lenders are subject to relatively heavy regulation. For example, bank regulators carefully scrutinize loan portfolios for credit quality, adequate reserves against loss, geographic concentration, industry concentration and interest rate sensitivity. However, the results of these examinations are largely kept between the government and the banks, to give internal guidance to the institution's fiscal management, and to detect any problems that might later require a bailout. The limits imposed by regulators on a loan portfolio are substantive a lender may only carry so many undercollateralized loans, so many loans in the software industry in the Southeast, and so on in order to protect the safety and soundness of the regulated institutions. Scrutiny of a loan portfolio can be close, but also is generally behind closed doors.

Transactions in securitized instruments, on the other hand, are governed by the securities laws. The sponsors must produce detailed disclosure documents for investors (e.g., "private placement memoranda" or "offering circulars") which describe the pooled loans. The production of these documents is expensive, due to the materiality, clarity and diligence standards required by the laws governing the securities markets. Under this regime of law, credit risks are not so much prohibited, as evaluated for quantifiability, uniformity and acceptability to the marketplace. The arrangers of a securitized offering induce third parties to purchase interests in the pooled loans by relying on their disclosure documents, without independent examination of the underlying obligations. (In contrast, a traditional lender seeking participants to purchase interests in a loan - that is, other investors on whom to lay off part...