No structural feature is more characteristic of securitization transactions than the transfer of the assets to be securitized to a special purpose bankruptcy remote entity ("SPE"). It is this transfer which, at least in theory, separates the assets from the credit strength of the originator and permits the issuance of investment grade securities by the SPE. It is this transfer which is the subject of the true sale and nonconsolidation opinions which are almost as universal to asset securitization as the SPE itself.
Lease residuals derive from the market value of the leased equipment upon the expiration of the lease term. If a pool of leased equipment whose residual values are to be securitized is owned by the leasing company, the equipment will be transferred to the SPE issuing the residual securities ("Residual Securitization SPE"). If, however, the leases themselves have already been securitized, then the equipment will probably be owned by the SPE involved in the lease securitization ("Lease Securitization SPE").
In such a case, the residuals may be represented by a junior security issued by the Lease Securitization SPE and/or the right to receive payments form the bottom of the lease securitization waterfall. In such a case, it is these junior securities or interests that must be transferred to the Residual Securitization SPE. It can thus be seen that the particular structure of a residual securitization will necessarily be determined in large part by the manner in which the related leases have been financed. This being the case, one way to explore some of the structuring issues which might arise in connection with a residual securitization is to consider a hypothetical example.
Let us assume that a leasing company has in place five separate lease securitizations for separate pools of leases. The principal balance of the lease securitization securities is, in each case, the discounted present value of the remaining scheduled payments under the pooled leases, determined in each case by utilizing a discount factor equal to the interest rate applicable to the securitization securities plus the applicable servicing and trustee fees (each expressed as a percentage). The lease-backed securities are enhanced by a separate cash reserve for each securitization and the residual values of the related equipment (which has been transferred to the Lease Securitization SPEs along with the leases).
Proceeds of equipment dispositions following the expiration of each lease are run through the applicable lease securitization waterfall. This results in the equipment residuals being utilized to cover any shortfalls (defaults) on scheduled lease payments and to restore the cash reserve to its specified level. Residual values not so utilized flow to the bottom of the waterfall and are paid out to the leasing company (which holds the junior securities issued by each Lease Securitization SPE).
On the basis of the past performance of its lease portfolio and its residual realization experience, the leasing company expects to receive substantial payments on the junior securities it holds from each of the five lease securitizations. To securitize these residuals, the leasing company needs simply to transfer these five junior securities to a Residual Securitization SPE. The Residual SPE will then issue securities backed by or representing the right to receive the payments on the five junior lease-backed securities as these payments are received.
The basic residual securitization structure outlined above is in its pure form even more simple than any of the original lease securitizations. After all, only five assets--the five junior lease-backed securities--need be transferred. However, certain practical and legal concerns are likely to complicate this basic structure.
Restrictions on Transfer
Under the terms of many lease securitizations, the junior lease-backed securities are not transferable. Restrictions on transfer have frequently been imposed out of concern that the transfer could jeopardize the tax treatment of the lease securitization itself. (Junior lease-backed securities are often viewed from a tax standpoint as representing the equity interest in the Lease Securitization SPE, which justifies debt treatment for the investor-held senior securities).
Transfer of junior lease-backed securities may also be prohibited out of a concern that third parties holding such securities could attempt to disrupt the securitization structure or for other reasons. Without going into further detail, it is sufficient to note that the restrictions on transfer typically applicable to junior lease-backed securities are probably more broad than necessary due to the fact that, when the lease securitization was itself structured, no though was given to the possible further transfer of residuals prior to termination of the lease securitization.
The lesson for those currently doing lease securitizations is to seek to eliminate or minimize restrictions on transfer of residual pieces. If these restrictions cannot be eliminated completely, it should be possible to limit them so as to facilitate a future residual securitization. For example, a lease securitization might permit transfer of a junior lease-backed security to a Residual Securitization SPE if, by the terms of such transfer, the Residual Securitization SPE agrees not to take any action which could interfere with the lease securitization.
Those leasing companies that wish to securitize residuals represented by junior lease-backed securities which are subject to restrictions on transfer may be able to solve this problem by transferring the right to receive all payments on such securities without actually transferring the securities themselves. The success of such an approach will depend on the ability of the leasing company's counsel to give a true sale and other supportive opinions and on the level of comfort that investors and the rating agencies which rate the residual securities have with the approach taken.
At some point before the maturity of a residual securitization, one or more of the underlying lease securitizations will be paid off. Moreover, this may occur even earlier than the nominal maturity of the lease securitization due to the typical clean-up call that kicks in when the remaining balance of the securitization equals no more than 5% or 10% of the original transaction amount. In the absence of a residual securitization, at the end of a lease securitization transaction any remaining leases and equipment will generally be transferred back to the leasing company. If, however, the residual interests have been sold to a Residual Securitization SPE, the equipment and leases must be transferred to it.
This means that, in our example, the original pool of five junior lease-backed securities may, over time, turn into a pool of leases and equipment. Thus, the residual securitization will need to deal with all of the same issues that a lease securitization typically addresses: Equipment, such as motor vehicles, subject to certificate of title statutes will need to be transferred in a manner consistent with those statutes (perhaps making use of titling trusts); precautionary security interests in other types of equipment may require UCC filings in multiple states where such equipment is located; possible tax issues associated with the equipment transfers must be addressed, and servicing provisions must provide for the marketing and disposition of the equipment.
Income Tax Consideration
A leasing company will consider residual securitization because it wishes to accelerate the receipt of a substantial part of the value of its residuals. The same leasing company, however, will generally not want to accelerate the recognition of this income for tax purposes. Moreover, because buyers of residuals are not likely to pay what the leasing company believes their true value to be, the leasing company will likely want to retain the upside potential represented by a junior interest in the Residual Securitization SPE just as it retains the junior security in a lease securitization.
These factors taken together generally mean that a leasing company will want to structure a residual securitization so that the transfer of residuals to the Residual Securitization SPE will be ignored for income tax purposes. One approach to achieving this result for federal and most state income tax purposes is to organize the Residual Securitization SPE as a single member limited liability company that is wholly owned by the leasing company. Depending on accounting objectives, the securities are then issued either as debt instruments or as trust certificates (equity interests for at least some state law purposes) that are treated as debt for tax purposes.
Unlocking the Maximum Residual Values
Because the junior lease securitization securities held by a Residual Securitization SPE are dependent on both the actual residual realization on the underlying equipment and the performance of the lease securitizations, the value of the junior lease securitization securities is considerably more difficult to assess than the value of a stream of fixed payment obligations. This means that, without further enhancement, the purchaser of residual-backed securities is likely to require considerable over collateralization which will reduce significantly the proceeds of the residual securitization.
However, if the residual securities are supported by a residual value policy, letter of credit or similar instrument issued by a credit worthy third party, the purchasers of the residual backed securities might well be willing to finance up to 100% of the projected residual values. Such 100% residual financing will not likely be possible, however, since any third party enhancement provider will, in all probability, itself require some level of over collateralization.
If, however, the enhancement provider is more experienced and expert in residual valuation than the usual purchasers of asset backed securities, this over collateralization may be far less than would be required for a residual securitization transaction without third party support. Thus, the all-in cost of residual securitization may be reduced by the inclusion of a third party enhancement provider even though such inclusion will complicate the transaction structure.
Reprinted with permission from the July/August 1998 issue of the "Leasing and Financial Services Monitor."