A s an alternative to the issuance of a corporate bond, a corporation

can issue a security backed by loans or receivables. Securities that have as their collateral loans or receivables are referred to as asset- backed securities. The transaction in which asset-backed securities are created is referred to as a structured finance transaction or structured financing. In this chapter, we will explain what is meant by a structured finance transaction, the reasons why a corporation would use a structured finance transaction rather than issue a corporate bond, and how rating agencies assess the credit risk of a structured finance transaction. While our focus in this chapter is on structured financing used by corporations, it should be noted that some municipal governments use this form of financing rather than issuing municipal bonds and several Euro- pean central governments use this form for financing.

WHAT IS A STRUCTURED FINANCE TRANSACTION? The term “structured ﬁnance” refers to a wide variety of debt and

related securities. The key element of structured ﬁnancing is that the obligation of the issuer to repay lenders is backed by the value of a ﬁnancial asset or credit support provided by a third party to the transac-

tion. 1 When we say the value of a “ﬁnancial asset” we mean a loan, an account receivable, or a note receivable. Keep in mind that a loan or a

1 Andrew A. Silver, “Rating Structured Securities,” Chapter 5 in Issuer Perspectives on Securitization (New Hope, PA: Frank J. Fabozzi Associates, 1998), p. 5

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receivable is a ﬁnancial asset to the lender but a liability to the borrower. So, in a structured ﬁnancing, the lender is using a pool of loans or receivables as collateral for debt instruments that it issues. To obtain

a desired credit rating sought by a corporation for the asset-backed securities created by using a structured ﬁnancing, both the value of the ﬁnancial assets and a third-party credit support may be needed.

In Chapter 15 where we discuss intermediate- and long-term debt instruments, we described secured debt instruments whose credit stand- ing is supported by a lien on specific assets (i.e., a mortgage bond or collateral trust bond) or by a third-party guarantee. However, with traditional secured bonds, it is the ability of the issuer to generate sufficient earnings to repay the debt obligation that is necessary for the issuer to repay the debt. So, for example, if a manufacturer of farm equipment issues a mortgage bond in which the bondholders have a first mortgage lien on one of its plants, the ability of the manufacturer to generate cash flow from all of its operations is required to pay off the bondholders.

In contrast, in a structured financing, the burden of the source of repayment shifts from the cash flow of the issuer to the cash flow of the pool of financial assets and/or a third-party that guarantees the pay- ments if the pool of financial assets does not generate sufficient cash flow. For example, if the manufacturer of farm equipment has receivables from installment sales contracts to customers (i.e., a financial asset for the farm equipment company) and uses these receivables in a structured financing as described in this chapter, payment to the buyers of the bonds backed by these receivables depends only on the ability to collect the receivables. That is, it does not depend on the ability of the issuer to generate cash flow from operations.

The process of creating securities backed by a pool of ﬁnancial assets is referred to as asset securitization. The ﬁnancial assets included in the collateral for an asset securitization are referred to as securitized assets.

The issuers of asset-backed securities include: ■ Captive finance companies of manufacturing firms that provide financ-

ing only for their parent company’s products. ■ Financing subsidiaries of major industrial corporations. ■ Independent ﬁnance companies.

■ Domestic and foreign commercial banks. An example of the ﬁrst type of issuer is the captive ﬁnance compa-

nies of automobile manufacturers. For example, Ford Credit is a captive finance company of Ford Motor Company. It provides financing for individuals who want to purchase a motor vehicle or commercial financ-

Borrowing Via Structured Finance Transactions

ing for companies that want to purchase a ﬂeet of motor vehicles manufactured by Ford Motor Company.

Financing subsidiaries of major industrial corporations provide financing for not only their parent company’s products but products of other vendors. Three examples are GE Capital Commercial Finance, IBM Global Financing, and Caterpillar Financial. GE Capital Commer- cial Finance, a wholly-owned subsidiary of General Electric, is a diversi- fied financial servicing company. IBM Global Financing is a wholly- owned subsidiary of IBM that provides financing for both IBM and non- IBM equipment. Caterpillar Financial, the financial arm of Caterpillar Inc. (the world’s largest manufacturer of construction and mining equipment, natural gas and diesel engines, and industrial gas turbines) offers

a wide range of ﬁnancing alternatives for Caterpillar equipment, Solar gas turbines, products equipped with Caterpillar components, fork lift trucks manufactured by Mitsubishi Caterpillar Forklift of America, Inc., and related products sold through Caterpillar dealers.

ILLUSTRATION OF A STRUCTURED FINANCE TRANSACTION Let’s use an illustration to describe a structured ﬁnance transaction.

(We’ll review an actual structured financing transaction at the end of this chapter after we have explained all of the key features in these transactions.) In our illustrations throughout this chapter, we will use a hypothetical firm, Farm Equip Corporation. This company is assumed to manufacturer farm equipment. Some of its sales are for cash, but the bulk of its sales are from installment sales contracts. Effectively, an installment sale contract is a loan to the buyer of the farm equipment who agrees to repay Farm Equip Corporation over a specified period of time. For simplicity we will assume that the loans are typically for four years. The collateral for the loan is the farm equipment purchased by the borrower. The loan specifies an interest rate that the buyer pays.

The credit department of Farm Equip Corporation makes the deci- sion as to whether or not to extend credit to a customer. That is, the credit department will receive a credit application from a customer and, based on criteria established by the ﬁrm, will decide on whether to extend a loan and the amount. The criteria for extending credit or a loan are referred to as underwriting standards. Because Farm Equip Corporation is extending the loan, it is referred to as the originator of the loan.

Moreover, Farm Equip Corporation may have a department that is responsible for servicing the loan. Servicing involves collecting pay-

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ments from borrowers, notifying borrowers who may be delinquent, and, when necessary, recovering and disposing of the collateral (i.e., farm equipment in our illustration) if the borrower does not make loan repayments by a speciﬁed time. While the servicer of the loans need not

be the originator of the loans, in our illustration we are assuming that Farm Equip Corporation is the servicer. Now let’s get to how these loans can be used in a structured ﬁnance transaction. We will assume that Farm Equip Corporation has more than $200 million of installment sales contracts. This amount is shown on the corporation’s balance sheet as an asset. We will further assume that Farm Equip Corporation wants to raise $200 million. Rather than issuing corporate bonds for $200 million (for the reasons explained in the next section), the treasurer of the corporation decides to raise the funds via a structured ﬁnancing.

To do so, the Farm Equip Corporation will set up a legal entity referred to as a special purpose vehicle (SPV). At this point, we will not explain the purpose of this legal entity, but it will be made clearer later that the SPV is critical in a structured ﬁnance transaction. In our illustration, the SPV that is set up is called FE Asset Trust (FEAT). Farm Equip Corporation will then sell to FEAT Company $200 million of the loans. Farm Equip Corporation will receive from FEAT $200 million in cash, the amount it wanted to raise. But where does FEAT get $200 million? It obtains those funds by selling securities that are backed by the $200 million of loans. The securities are the asset-backed securities we referred to earlier. These asset-backed securities issued in a structured ﬁnance transaction are also referred to as bond classes or tranches.

The structure is diagrammed in Exhibit 26.1. EXHIBIT 26.1 Structured Financing

Buy equipment

Customers Farm Equip Corporation

Make a loan

Pay cash for loans Sell securities

Sell customer loans

Investors FE Asset Trust

Cash

Borrowing Via Structured Finance Transactions

A simple transaction can involve the sale of just one bond class with

a par value of $200 million. We will call this Bond Class A. Suppose that 200,000 certificates are issued for Bond Class A with a par value of $1,000 per certificate. Then, each certificate holder would be entitled to 1/200,000 of the payment from the collateral. Each payment made by the borrowers (i.e., the buyers of the farm equipment) consists of principal repayment and interest.

A structure can be more complicated. For example, there can be rules for distribution of principal and interest other than on a pro rata basis to different bond classes. It may be difﬁcult to understand why such a structure should be created. What is important to understand is that there are institutional investors who have needs for bonds with different maturities and price volatility characteristics. A structured ﬁnance transaction can be designed to create bond classes with invest- ment characteristics that are more attractive to institutional investors to satisfy those needs.

An example of a more complicated transaction is one in which two bond classes are created, Bond Class A1 and Bond Class A2. The par value for Bond Class A1 is $90 million and for Bond Class A2 is $110 million. The priority rule can simply specify that Bond Class A1 receives all the principal that is paid by the borrowers (i.e., the buyers of the farm equipment) until all of Bond Class A1 has paid off its $90 million and then Bond Class A2 begins to receive principal. Bond Class A1 is then a shorter term bond than Bond Class A2.

As will be explained later, there are structures where there is more than one bond class but the two bond classes differ as to how they will share any losses resulting from defaults of the borrowers. In such a structure, the bond classes are classiﬁed as senior bond classes and sub-

ordinate bond classes. This structure is called a senor-subordinate

structure. Losses are realized by the subordinate bond classes before there are any losses realized by the senior bond classes. For example, suppose that FEAT issued $180 million par value of Bond Class A, the senior bond class, and $20 million par value of Bond Class B, the subordinate bond class. As long as there are no defaults by the borrower greater than $20 million, then Bond Class A will be repaid fully its $180 million.

A s an alternative to the issuance of a corporate bond, a corporation