The Potential for Reducing Funding Costs To understand the potential for reducing funding costs by issuing an

The Potential for Reducing Funding Costs To understand the potential for reducing funding costs by issuing an

asset-backed security rather than a corporate bond, suppose that Farm Equip Corporation has a triple B credit rating. If it wants to raise funds equal to $200 million and it issues a corporate bond, its funding cost would be whatever the benchmark Treasury yield is plus a yield spread for triple B issuers. Suppose, instead, that Farm Equip Corporation uses $200 million of its installment sales contracts (i.e., the loans it has made to customers) as collateral for a bond issue. What will be its funding cost? It probably will be the same as if it issued a corporate bond. The reason is that if Farm Equip Corporation defaults on any of its out- standing debt, the creditors will go after all of its assets, including the loans to its customers.

However, suppose that Farm Equip Corporation can create another legal entity and sell the loans to that entity. That entity is the special purpose vehicle that we described earlier in our hypothetical structured finance transaction. In our illustration, it is Farm Equipment Asset Trust (FEAT). If the sale of the loans by Farm Equip Corporation to FEAT is done properly—that is, the sale is at the fair market value of the loans— FEAT then legally owns the receivables, not Farm Equip Corporation. This means that if Farm Equip Corporation is forced into bankruptcy, its creditors cannot try to recover the loans (sold to FEAT) because they are legally owned by FEAT. What is the implication of structuring a transaction in this way?

When FEAT sells bonds backed by the loans, those interested in buying the bonds will evaluate the credit risk associated with collecting the payments due on the loans independent of the credit rating of Farm Equip Corporation. What credit rating will be received for the bonds issued by FEAT? Whatever FEAT wants the credit rating to be! It may seem strange that the issuer (the SPV, FEAT) can get any credit rating it wants, but that is the case. The reason is that FEAT will show the char- acteristics of the collateral for the asset-backed securities (i.e., the loans to Farm Equip’s customers) to a rating agency. In turn, the rating agency will evaluate the credit quality of the collateral and inform the issuer what must be done to obtain a desired credit rating.

Borrowing Via Structured Finance Transactions

More specifically, the issuer will be asked to “credit enhance” the structure. There are various forms of credit enhancement that we will review later. Basically, the rating agencies will look at the potential losses from the collateral and make a determination of how much credit enhancement is needed for the bond classes issued to achieve a rating targeted by the issuer. The higher the credit rating sought by the issuer, the more credit enhancement a rating agency will require. Thus, Farm Equip Corporation which is triple B rated can obtain funding using its loans to its customers as collateral to obtain a better credit rating for the bonds issued than its own credit rating. In fact, with enough credit enhancement, it can issue a bond of the highest credit rating, triple A.

The key to a corporation issuing bonds with a higher credit rating than the corporation’s own credit rating is the SPV. Its role is critical because it is the SPV (FEAT in our illustration) that separates the assets used as collateral from the corporation that is seeking financing (Farm Equip Corporation in our illustration).

Why doesn’t a corporation always seek the highest credit rating (tri- ple A) for the bonds backed by the collateral in a structured financing? The answer is that credit enhancement does not come without a cost. As described later, there are various credit enhancement mechanisms and they increase the costs associated with securitized borrowing via an asset- backed security. So, the corporation must assess the tradeoff when it is seeking a higher rating between the additional cost of credit enhancing the bonds versus the reduction in funding cost by issuing a bond with a higher credit rating.

It is important to realize that if a bankruptcy of the corporation seek- ing funds occurs (Farm Equip Corporation in our example), a bankruptcy judge may decide that the assets of the SPV are assets that the creditors of the corporation seeking financing may go after. This is an unresolved legal issue in the United States. Legal experts have argued that this is unlikely. In the prospectus of an asset-backed security, there will be a legal opinion addressing this issue. This is the reason why special purpose vehicles in the United States are referred to as “bankruptcy remote” entities.