Asset Securitization PDF

DIMENSION 6 - 38 NOTES: Asset securitization involves three steps as illustrated below: Step 1: Isolate assets with a predictable cash flow. Step 2: Package the assets. CRC US Body of Knowledge Step 3: Sell the securities in the market. DIMENSION 6 - 39 The primary reasons for the rapid growth in as...

DIMENSION 6 - 38 NOTES: Asset securitization involves three steps as illustrated below: Step 1: Isolate assets with a predictable cash flow. Step 2: Package the assets. CRC US Body of Knowledge Step 3: Sell the securities in the market. DIMENSION 6 - 39 The primary reasons for the rapid growth in asset securitizations are as follows: Off-balance sheet financing: Originators of loans or companies with accounts receivable can improve their return on capital and lower their cost of funds by selling and securitizing on-balance sheet assets, thus reducing on-balance sheet leverage and freeing up capital for further origination and servicing. High quality assets: Many investors with quality and/or maturity restrictions find AAA-rated asset-backed securities a highly attractive alternative to government, agency, and single-A and BBB-rated corporate bonds. Success of the asset-backed market: to date, highly rated asset-backed securities have performed consistently with their ratings, increasing investor confidence and broadening the market. COLLATERAL CONSIDERATIONS Investors should analyze the underlying quality of the assets collateralizing the securities. Rating agencies can also provide this credit determination. As stated earlier, credit enhancements are an important part of asset-backed structures. The key factors to consider will vary depending upon the type of collateral (auto loans, credit cards, etc.) and forms of credit enhancements (guarantees, collateral values, etc.). SOURCES OF REPAYMENT For most asset-backed securities, the more important consideration is how variable the cash flows are. The major factors influencing the timing of cash flows are as follows: Early amortization of principal caused by defaults, refinancings, and prepayments of principal. Default by the servicer. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. PURPOSE DIMENSION 6 - 40 NOTES: KEY RISKS There are two sources of risk with asset-backed securities: Risk of loss of principal due to defaults of loans or accounts receivable in the collateral pool. Risk of the timing of interest and principal payment will differ with expectations, altering the anticipated return on investment. In addition to the agency rating, the investor needs to analyze the pool of assets and the forms of credit enhancement in order to make an independent determination of risk of loss. LOAN SUPPORT AND COVENANTS When does the form of an organization suggest a guarantee is needed? The borrower’s form of organization influences whether a guarantee may be needed. The following paragraphs briefly describe typical considerations for whether the borrower’s form of organization suggests the need for a guarantee. Generally, for privately held borrowers a guarantee is highly desirable whenever the form of organization does not already incorporate personal liability (i.e., the borrower is not a proprietorship or a general partnership). In addition, guarantees are highly recommended when there are multiple legal entities sharing the same ownership, and when it is possible for the borrower’s financial resources to be easily redistributed within those entities. CORPORATION CRC US Body of Knowledge The loan policies of most lenders require that a corporation’s major stockholders guarantee a loan to a closely held corporation. Sometimes, a corporation may be asked to guarantee the debt of another entity. For example, a holding company may be asked to guarantee the debt of a subsidiary. The shareholders, directors, officers and employees are not otherwise liable for corporate debt. LIMITED LIABILITY COMPANY The loan policies of most lenders also require that a limited liability company’s members guarantee a loan to the limited liability company. Otherwise, the members have no individual liability for the debts of the company DIMENSION 6 - 41 General partners may be required to guarantee a partnership debt, even though the general partners are legally liable for partnership debt. The guarantee agreement allows you to act sooner. Without the guarantee, you would have to exhaust all efforts against the partnership before you could take action against the individual partners. LIMITED LIABILITY PARTNERSHIP AND LIMITED LIABILITY LIMITED PARTNERSHIP Most banks’ loan policies require that partners in the limited liability partnership guarantee a loan to the partnership and that the general partners in a limited liability limited partnership guarantee a loan to the partnership. Otherwise, the partners have no individual liability for partnership debts incurred by the partnership after registration as a limited liability partnership or limited liability limited partnership. SPOUSE Spouses of the original borrower and guarantors should be required to execute a guarantee in community property states. Ten states—Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin—use some form of the community property system to determine the interest of a husband and wife in property acquired during marriage. Under the community property system, the general rule is that all property acquired during the marriage is community property, owned one-half by each spouse. Property received by inheritance or gift and property owned before marriage is separate property. Consult with your legal counsel. If an applicant requests unsecured credit, federal law permits requests for a guarantee from a spouse. The creditor must believe it reasonably necessary under applicable state law to make the community property available to satisfy the debt in the event of default, and, either: The applicant lives in a community property state, or The property upon which the applicant is relying to demonstrate creditworthiness is located in a community property state. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. LIMITED PARTNERSHIP AND GENERAL PARTNERSHIP DIMENSION 6 - 42 NOTES: Two additional conditions must be met. Under the creditor’s standards of creditworthiness: Applicable state law must deny the applicant power to manage or control sufficient community property to qualify for the amount of credit requested. The applicant cannot have sufficient separate property to qualify for the amount of credit requested. In non-community property states, federal law prohibits requests for a guarantee from a spouse. A lender may request “more creditworthy co-guarantors” and may accept guarantees of spouses if the guarantors volunteer them. COLLECTION FROM A GUARANTOR IN EVENT OF DEFAULT Most states provide guarantors with legal defenses and claims against the lender that can make collection difficult. Your position is strengthened if you obtain evidence that the guarantor understands the terms of the loan. You should not make subsequent changes to the loan without a written statement of understanding and consent by the guarantor, as well as a written confirmation that the guarantee is not affected by the change. You should also notify the guarantor of any defaults that occur in the underlying credit transaction. This is required by law in some states. CRC US Body of Knowledge In certain states, guarantees are subject to the statute of limitations. Consequently, in these states, renewals of the guarantee should be obtained. If in doubt, ask your legal counsel. A guarantee, by its terms, can be revoked at any time but only as to debt incurred after the revocation. The guarantor simply notifies the lender in writing that it no longer will guarantee the loan of the borrower. The guarantor, however, remains liable for existing debt and committed future amounts when the commitment was made prior to the revocation. REQUIREMENTS The guarantee agreement must be signed on or prior to the date of the note so that there is no question of consideration to the guarantor. Consideration may consist either of actual value (money or other things of value) given to the guarantor or your reliance on the guarantee in making your credit decision. DIMENSION 6 - 43 Special Consideration for Enforcing Small Business Association (SBA) Guarantees If you have obtained an SBA guarantee for your loan, your ability to collect on that guarantee could depend on the following: Did you close the loan in accordance with the SBA authorization letter, as appropriately amended? Did you comply with the monitoring and credit management requirements of the authorization? Did you act with normal prudence for the industry and comply with the rules and regulations of the SBA in managing the liquidation? COMFORT LETTERS Comfort letters are letters issued to lenders by companies to indicate support for another entity borrowing from the lender. They are sometimes offered and accepted in lieu of guaranties. They are most often issued by parent companies in connection with subsidiary borrowings. They generally fall short of an absolute promise to pay the borrowing entity’s debt. Companies that favor comfort letters are generally public companies that do not want to have to include contingent liabilities in their financials. Comfort letters are enforceable. They are an adequate substitute for guaranties only if they contain a solid commitment of the issuer to step up to repayment obligations incurred by its subsidiary. You should attempt to find out how the issuer has performed under similar previous arrangements. For articles that discuss credit issues related to guarantees, see the Loan Guarantees Credit and Lending Studies Pack by RMA. For help in understanding how to document guarantees, see the Loan Documentation section of this Dimension. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. If not signed in your presence or that of another official of your institution, you should require a signature guaranty from a financial institution acceptable to you. The signature guaranty indicates that an authorized officer or employee of the institution guarantying the signature has witnessed the signing and verified the identity of the signer. If the signature later proves to have been unauthorized or fraudulent, the guarantying institution will be liable for any damages you suffer. DIMENSION 6 - 44 NOTES: LOAN COVENANTS Loan covenants are a part of the formal loan agreement and outline certain acts that are to be performed (affirmative covenants) and others that must be refrained from (negative covenants). They are designed to protect the bank’s interest. They are also an essential complement to monitoring the relationship and provide early warning signs of a troubled credit. COVENANTS ACCOMPLISH THE FOLLOWING: Covenants are designed to protect the bank. A covenant is to be drawn sufficiently tight to protect the bank while at the same time providing flexibility to the company to allow the business to be run effectively. Covenants should identify key risk points in the company’s operating profile. In establishing these guidelines, it is very important to identify the specific risks against which the bank needs to be protected and to prevent certain actions by the company that could jeopardize the timely repayment of the loan. Covenants should be those that the bank expects to enforce. As a bank, the discipline of using only those covenants that you intend to enforce is important. Including covenants that are not enforced gives rise to confusion, negotiating lapses, and inconsistencies— particularly when the bank tries to enforce other covenants in the loan agreement. CRC US Body of Knowledge Covenants provide timely warning signs. Covenants provide the bank with a mechanism that raises warning flags in the event of deterioration in a company’s financial performance, as well as guidelines within which a company’s operating and financial performance must comply. Covenants bring the borrower back to the table. More important, covenants provide the bank with the means of bringing the borrower back to the negotiating table to restructure the loan in the event established guidelines are breached. Covenants do not repay loans. In determining appropriate covenants, always remember that covenants, no matter how well crafted, do not repay the bank’s loan. DIMENSION 6 - 45 The following paragraphs explain covenant objectives and provide examples of specific covenants that can achieve those objectives. Covenant objectives we will discuss are: Full disclosure of information. Protection of net worth. Protection of cash flow. Protection of asset quality. Control growth. Maintenance of key management. Assurance of legitimacy and the company as a going concern. Profitability for the bank. See the Dimension 6 discussion of loan documentation for additional terms and conditions generally included with covenants in loan agreements. FULL DISCLOSURE OF INFORMATION To make competent, ongoing lending decisions, the bank must have an in-depth understanding of the company. This understanding only comes with full and timely disclosure. Full disclosure also helps maintain regular contact with the company and close control over the lending relationship. NOTES: Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. In crafting a covenant package, it is important to determine your key objectives to ensure effective monitoring and management of the exposure and to assure the bank of the optimal chance of repayment. DIMENSION 6 - 46 The following are some covenants that provide full disclosure of information: AFFIRMATIVE COVENANTS Timely delivery of financial information Delivery of financial statements is defined (if audited, within 120 days of fiscal year end; if unaudited, within up to 120 days of year end, or if delivered on a more frequent basis, 5, 10, 20, or up to 30 days after the end of the accounting period in question). An officer’s certification attesting to the accuracy of the information should accompany all internal financial information and indicate compliance/noncompliance with all covenants. Timely delivery of business plans Include a minimum of 3 years’ projections. Timely delivery of an auditor’s management letter Delivery of an auditor’s letter stating that the company complies with all of its loan agreements and indicating whether or not any event of default has occurred under any of the company’s loan agreements is specified. Consistent preparation of financial statements The auditor’s letter should also state that there has been no change in the basis on which financial statements have been prepared and, in addition, that such financial statements have been prepared using accounting procedures that remain consistent with previous financial statements and in accordance with GAAP. CRC US Body of Knowledge Location of the company’s books and records The company’s books and records will be maintained in a specific location and will be available for inspection by the bank. Maintenance of rights of inspection Representatives of the bank shall be permitted to inspect any or all records and property to verify the actual confirmed ownership of the property and other assets, the authenticity of the furnished statements evidencing ownership of such assets (that should also include, where appropriate, either a landlord’s waiver or a mortgagee’s waiver), as well as the actual condition of the assets. Timely delivery of information on contingent liabilities Delivery of any information of actual or probable litigation or changes in contracts or the status quo that might affect the company’s business is indicated. Maintenance of operating accounts with the bank All principal operating accounts are to be maintained with the bank. DIMENSION 6 - 47 Notwithstanding the significant importance of cash flow, much of a company’s basic financial strength, intrinsic debt capacity, and its ability to absorb downturns lie in the amount and quality of its net worth. Net worth covenants always should be targeted at assuring the continued strength and growth of net worth. The following are examples of covenants that protect net worth: AFFIRMATIVE COVENANTS Maintenance of minimum tangible net worth The maintenance of a minimum tangible net worth will ensure an adequate cushion for the senior debt provider, particularly when combined with carefully crafted maximum leverage ratios. Note: Such covenants should include the formula for the calculation of minimum tangible net worth, and, most important, this formula or basis for calculation always should be communicated and explained to the customer. With a seasonal loan, this covenant can still be reinforced, provided the bank has retained the right to receive regular and timely financial statements. Other financial ratios With seasonal and other permanent working capital loans, banks can monitor the maintenance of such ratios as sales to net worth, net profit to net worth, and debt to depreciated capital assets. Maintenance of key person life insurance If the continued success of the company depends on one or two key individuals, key person life insurance, equal to the amount of the bank’s exposure, should be maintained with the benefits assigned to the bank. Current settlement of tax liabilities and other accrued expense obligations Tax payments should be made as they fall due, insurance premiums should be kept up to date, and restrictions on the cash payment of accrued officers’ salaries may also be appropriate. Timely delivery of information on contingent liabilities Delivery of any information of actual or probable litigation or changes in existing contracts that might affect the business should be specified. Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. PROTECTION OF NET WORTH DIMENSION 6 - 48 CRC US Body of Knowledge NEGATIVE COVENANTS Restrictions on change of ownership and management No change permitted in the management or ownership of the company. May not be applicable to a public company. Restrictions on repurchase of stock/ payment of dividends Restrictions placed on dividend payments, the repurchase of stock, or disguised reductions of equity such as higher officers/shareholders’ salaries, loans to officers/shareholders, or loans to affiliates and/ or subsidiaries, inflated rental expenses paid to affiliates, or transfer pricing considerations as between affiliates. Restrictions on mergers or other changes in the business Activities that may indirectly negatively impact the equity capital base including restrictions on mergers and acquisitions or a material change of business are restricted. Restrictions on additional borrowings Even if the existing bank is secured, it is important that additional borrowings from other sources are curbed to preserve cash flows for servicing the existing bank’s debt. This restriction should also extend to other forms of financing such as leases, affiliated company loans, or shareholder loans unless they are on terms that strengthen the existing bank’s loan. Financial ratios Restrictions on leverage can be imposed as maximum leverage: total liabilities to tangible net worth. Maximum leverage: funded bank debt to tangible net worth. Restrictions on sales of assets While more important in permanent working capital and term loans, fixed assets—in particular plant and machinery—may be a very important way out for the unsecured bank or for the bank secured only by current assets, should the latter be insufficient to liquidate the loan. As a result, restrictions on sales of assets are important, even in the case of a seasonal loan. Finally, since in nearly all cases these fixed assets are essential for generating the future cash flows of the company, removal of the source of these cash flows should be prevented. DIMENSION 6 - 49 PROTECTION OF CASH FLOW Following are examples of specific covenants that protect cash flow: AFFIRMATIVE COVENANTS Maintenance of minimum levels of cash flow This objective can be achieved by using financial covenants that address minimum interest coverage, minimum fixed charge coverage (all debt service and lease payments), and minimum cash flow to current maturities. Derivation of these covenants will comprise variations including: EBIT / Interest EBITA / Interest EBITDA / Interest EBITDA - Capital expenditures / Interest EBITDA - Capital expenditures - Change in adjusted working capital / Interest + CMLTD Net income + Depreciation / CMLTD Funded debt / EBITDA Note: EBITDA = Earnings before interest, taxes, depreciation, and amortization of noncash charges; CMLTD = current maturities of long-term debt. Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. Under most commercial bank credit policies, cash flow is regarded as the primary source of repayment. The bank should have every opportunity to monitor the level of cash flow as well as to preserve its quality. DIMENSION 6 - 50 AFFIRMATIVE COVENANTS (CONT.) Maintenance of working capital and liquidity This affirmative financial covenant requires the maintenance of a minimum level of working capital. Greater control may be exercised with this covenant by excluding certain elements of working capital (for example, prepaid expenses) or allowing only a certain percentage of inventory to be included (for example, 50%), regardless of whether or not the loan is secured. Current ratio: Working capital can also be linked to a minimum current ratio. This ratio, combined with the insistence on timely delivery of financial statements, particularly during the season, ensures that the bank has the ability to move quickly in the event of a material decline in asset values. Quick ratio: Use of a quick ratio can be an extremely powerful tool, particularly as a warning sign against the artificial improvement in liquidity created by, for instance, a buildup in slow moving inventory. Note: Such ratios may be very useful if applied over a full financial year or on a rolling four-quarter basis. However, recognize that during the buildup of inventory and receivables, the company may be experiencing a negative cash flow and negative interest coverage, until the contraction of the current assets being financed has occurred. As a result, a more effective tool may be to link working capital to sales as a means of ensuring efficiency in the management of working capital. A typical covenant, therefore, would be for working capital not to exceed a certain percentage of sales. CRC US Body of Knowledge Maintenance of property and casualty insurance Whether or not the bank is secured, the maintenance of insurance should be equal to the market value of the assets based on a current valuation from an acceptable valuation expert. DIMENSION 6 - 51 Restrictions on capital expenditures Limitations on investments in capital expenditures and lease expenditures and leases will be limited to levels that ensure sufficient cash for servicing and repayment of bank debt. Restrictions on investments Limitations on investments in capital expenditures and lease expenditures will be limited to levels that ensure sufficient cash for servicing and repayment of bank debt. Other covenants include restrictions on: Repurchase of stock/dividends Officers’ salaries Borrowings Sales of assets Mergers/change in business PROTECTION OF ASSET QUALITY This objective achieves the following: Protects the underlying cash flow generating power of the company—the primary source of repayment. Preserves the bank’s secondary source of repayment: the liquidation value of the assets. Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. NEGATIVE COVENANTS DIMENSION 6 - 52 The following are examples of covenants that protect asset quality: AFFIRMATIVE COVENANTS Maintenance of property, plant, and equipment in good repair Not only should a level of good repair be maintained, but the bank should also retain rights of access to inspect the property, plant, and equipment at the bank’s convenience. Also included are the following covenants: Maintenance of property and casualty insurance. Maintenance of key person life insurance. Current settlement of tax liabilities and other accrued expenses. Maintenance of minimum levels of working capital and liquidity ratios. Maintenance of rights of inspection. Maintenance of information on contingent liabilities. Maintenance of intellectual property rights, including trademarks, patents, formulas and licenses. NEGATIVE COVENANTS Restrictions on: Sales of assets. Capital expenditures. Leases. Loans to officers. CRC US Body of Knowledge Mergers or a change in the company’s business. DIMENSION 6 - 53 CONTROL GROWTH When companies grow, major drains on cash flow are caused by the investment in both working capital as well as fixed assets and increased dividend payments. With private companies, uncontrolled growth can be potentially damaging; therefore, an ability to monitor and, to some extent, control the rate of growth is important. The following are examples of specific covenants that control growth: AFFIRMATIVE COVENANTS Maintenance of minimum tangible net worth The maintenance of minimum tangible net worth is essential and will ensure an adequate cushion for the senior debt provided. Permanent working capital loans arise as a result of successful and unsuccessful, planned and unplanned growth patterns within companies. Interference with the evolution of a company’s growth profile can, in certain circumstances, create liability problems for the bank (see the Lender Liability discussion in Dimension 7). There are, however, a number of ways in which growth can be controlled without interfering with the day-today management of the company. These include restrictions on line availability, both in terms of absolute dollar amounts as well as through the judicious and conservative use of a formula-driven borrowing base. NEGATIVE COVENANTS Restrictions on: Working capital/sales. Borrowings and growth in leverage. Capital expenditures. Leases. Mergers or a change in the business. Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. This objective achieves the following: DIMENSION 6 - 54 MAINTENANCE OF KEY MANAGEMENT This objective achieves the following: Maintenance of a company’s management team, which ensures the company’s ability to repay debt. Continued quality of corporate management. Below are examples of specific covenants that maintain key management: AFFIRMATIVE COVENANTS Maintenance of employment contracts Examples of covenants that would specifically meet this objective include maintenance of contracts with key employees in a form acceptable to the bank. Other examples include key person life insurance, consistent accounting procedures, and rights of inspection. The timely delivery of financial statements is also specified. NEGATIVE COVENANTS Restrictions on: Mergers or a change of business. Change in management. CRC US Body of Knowledge Officers’ salaries. DIMENSION 6 - 55 Covenants should be established to ensure that the company remains a viable entity—legally and economically— to effectively service and repay its debt. Below are specific examples of covenants that assure legitimacy: AFFIRMATIVE COVENANTS Maintenance of corporate existence Preservation of the corporate entity including corporate licenses and other necessary legal filings. Maintenance of key person life insurance. Maintenance of information on contingent liabilities. Maintenance of pension funds. Maintenance of appropriate levels of insurance. Information regarding lawsuits. NEGATIVE COVENANTS Restrictions on: Asset sales. Mergers/acquisitions or a change in the business. Change in management or ownership. PROFITABILITY FOR THE BANK Covenants should be devised to maintain profitability for the bank—whether it is prepayment conditions in the event of fixed rate loans or penalty default interest in the event of problem loans. Below are specific examples of covenants that achieve profitability for the bank: AFFIRMATIVE COVENANTS Require: Maintenance of banking services, in particular checking accounts. Default pricing in loan agreements. Step-up or step-down pricing related to declines or improvements in operating performance. Dimension 6 // Identify Repayment Sources and Appropriately Structure and Document Credit Exposures for.. ASSURANCE OF LEGITIMACY AND THE COMPANY AS A GOING CONCERN