Below is a comment by LSU Professor Joseph Mason and Eric Higgins  on the evolving situation in the securitization market. While the folks at the Fed and Treasury pretend that they can breathe life back into the private label securitization market, the legal underpinnings of this OTC market are disintegrating under the weight of mounting losses and falling cash flow. –  Chris

Advanta and the Fiction of True-Sale

Joseph R. Mason and Eric J. Higgins†

On Monday, May 11, 2009, Advanta Corp. announced that their credit-card securitization trust would go into early amortization and that they will shut down all of the accounts in the trust. What the casual observer (and most regulators) missed is that this announcement is also endemic of the problems at the heart of securitization: the “true-sale” classification from which securitizations obtain their off-balance sheet treatment.

A company like Advanta issues credit-cards through its banking subsidiary (Advanta Bank). These credit card receivables are then sold into a trust (Advanta Business Card Master Trust). The trust then sells the cash flows from those receivables to investors. This trust is created as a truly-sold bankruptcy remote entity from Advanta Bank and Advanta Corp., allowing Advanta to treat the sale of credit-card receivables as off-balance sheet for regulatory and accounting purposes. Technically, Advanta Corp. has no liability for the assets that are sold into the trust and must not provide any recourse to the assets. This means that if those assets deteriorate in value, it is the problem of the trust investors, not Advanta.

The problem with the arrangement is that it has always been a complete fiction. Such was clearly pointed out in Advanta’s earnings call of April 30, 2009, where management first announced it was concerned about the performance of the credit-card trust. Management stated that they were worried that the trust might go into “early amortization, ” meaning the trust would cease to exist and would immediately begin to pay out all available credit-card receivables to investors in the trust.

Nonetheless, management said that, “… the Company has tools at its disposal which the Company believes will prevent early amortization if used. Management stated that the Company expects to use those tools unless it develops a plan that would better maximize capital and liquidity.” Back up a minute. The trust is supposed to be a separate entity from Advanta Corp. So Advanta is helping to bail out an unrelated entity with investor funds? That doesn’t make sense.

How can Advanta Corp. prevent early amortization without violating “true-sale” accounting? The truth is that they can’t. Providing recourse has historically been taken as implying that the receivables are assets of Advanta Corp. and should appear on their balance sheet. Since providing recourse directly is not allowed, companies like Advanta make statements like those above in order to give the market a sense that there is an implicit recourse guarantee.

Of course, the problem with implicit guarantees is that they are not legally binding. To see this consider Advanta’s May 11, 2009 announcement of the early amortization of their credit-card trust, where Advanta specifically says, “The securitization trust’s notes are obligations of the trust and not of any Advana entity.” What a difference a few days make. On April 30, 2009, management was going to save the securitization trust. On May 11, 2009, management is running away from the trust as fast as they can. Hence, when it is expeditious, firms can ignore true sale provisions and as soon as things get rough true sale provisions protect them.

This problem is not new. A study by Higgins and Mason (Journal of Banking and Finance 2004) looked at recourse provided by credit-card issuers in the mid-1990s. Higgins and Mason found evidence of 17 instances of recourse provided over the 1991-2001 time period that were specifically announced by the parent company. These recourse events helped support 89 separate credit-card securitizations that had a combined value of $35.4 billion.

During the study period, every one of those recourse events violated regulatory rules, but were carried out with a blessing from the regulators despite having recognized the problems of implicit recourse. The OCC published its first warnings on implicit recourse in 1996 and in 2002, the OCC, the Federal Reserve, and the Office of Thrift Supervision issued a joint guidance on implicit recourse in securitizations. The guidance identified specific acts of recourse that would violate true-sale accounting and should force the parent company to recognize the securitized assets on their balance sheet, including specifically the options considered by Advanta.

Since regulators have chosen to ignore implicit recourse, it has become institutionalized industry-wide. In their announcement regarding the downgrading of Advanta’s debt Fitch noted, “…early amortization would occur in the absence of intervention from Advanta within the next month. Intervention could come in the form of charge-off sales, a yield supplement account, or receivable discounting, as seen recently at other large card issuers.” Among those options, receivables discounting is specifically mentioned in the 2002 joint guidance as a prohibited recourse event that would force a parent company to take the securitized assets back on their balance sheets.

Moreover, such a statement means that Fitch – who rates asset-backed securities for a living – admits that they are, in part, basing their ratings on the expectation of implicit recourse being provided even though implicit recourse is : 1) a violation of true sale and 2) not contractually guaranteed.

The problem is that since recourse is not guaranteed, firms can choose to provide recourse when it is expedient and choose not to otherwise. Indeed, that is part of the story of the credit crisis, where mortgage issuers supported pool performance up until roughly mid-2007, when the pools were left to stand on their own. Because securitizations are off-balance sheet, banks can provide that support without holding capital against the activity, ostensibly because they can choose to put the risk to securitized investors if they wish to do so, which no going concern business will ever actually do. Hence, the saying on Wall Street is “the only securitization without recourse is the firm’s last.”

That capital, however, serves as a cushion against declining asset values and provides security to the government’s safety net (deposit insurance). In the run-up to the credit crisis, therefore, banks had too much managed leverage from securitization and not enough capital to provide the recourse that has historically been the sole means of support for troubled assets. As is usually the case, taxpayers are picking up the tab.

The solution is simple. Regulators simply need to enforce their existing rules. If a bank is selling assets with recourse, the bank has to hold capital against those assets as if they are on-balance sheet. Securitization is simple leverage. Securitization allows banks to borrow against their assets and increase their returns. None of this is rocket science. Given the lack of interest, however, it may take a few more failures to get meaningful regulatory changes.

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

12 Responses to “Securitization: Advanta and the Fiction of True-Sale”

  1. Cursive says:

    CW, have you done any appearances on the LSU campus? Admittedly it’s not a top tier university, but the Internal Audit and Forensic Accounting courses there are top notch. Full disclosure: I graduated through the LSU Internal Audit school run by Glenn Sumners. Also, the annual Fraud seminar is very good, at least the one I attended in 2006 was incredible. Maybe you’ve met Eddie Antar, the former CFO of “Crazy Eddie’s”? He definitely leaves an indelible impression.

  2. usphoenix says:

    I have believed the Advanta situation has been the prime example of the dirty dealings since the first moment I heard of it. And I think I’ve already posted my thoughts in Think Tank.

    If this is the level we’ve come to in the U S, then we have truly become corrupt beyond redemption, and nothing short of a total collapse is going to correct this mess.

    Everyone’s got blood on their hands and sh!t on their shoes.

  3. Cursive,

    it was, probably, Sam Antar that you saw. See: http://www.whitecollarfraud.com/

    Chris,

    these types of articles are Great. they, by themselves, prove Lie to the MSM-plaint: “Nobody understands/it can’t made to be understood..”. Yet, lo and behold, here it is!~ A clear, concise, straight-forward explaination of the Scene–that anyone, who was interested in reading, could understand.

    Keep nocking those Arrows..

  4. mhdoc says:

    I have been using an Advanta credit card for my small web publishing business. The rates were decent and the billing statements well thought out.

    Since reading they were shutting down June 10 ? I have been logging in to their website regularly to see if they plan to give card holders any advanced warning. So far nothing has been said. The site is still selling their products and services as usual. Nice.

  5. Cursive says:

    @MEH

    Yes, it was Sammy Antar. My bad. I was thinking of Crazy Eddie’s and, you know…. I have since seen Sam on an episode of MasterMinds, which used to appear on CNBC and CourtTV. After his presentation at the fraud conference I attended, I asked him if he would ever invest in a publicly traded company. Without hesitation, he answered, “No, absolutely not.” Continuing, he explained that he only invested in commercial real estate (not sure how he has weathered that storm). Anyway, we had Cynthia Cooper (WorldCom) and a bunch of other excellent guests, but Sammy Antar is a showman, par excellence.

  6. Cursive says:

    “Hence, the saying on Wall Street is “the only securitization without recourse is the firm’s last.””

    This is a different kind of “liar’s loan,” but a liar’s loan nonetheless. The financial services industry has been trying to have its cake and eat it, too. Off-balance sheet SPV’s created to circumvent capital requirments ratios? Citibank, are you listening?

  7. drollere says:

    “the solution is simple” always makes me expect the next words are going to be: “baby jesus needs to come down and kick some ass.”

    yes, the solution is simple, so what is the solution? do we need to write to our congressmen, write to the sec or the ftc or to the fed or to the president? do we need to consolidate regulatory agencies, fire regulators, retrain regulators, hire new regulators, create new accounting standards, create a new regulatory agency, change incorporation laws, change securitization laws, pass a law that says “you know that other law? we really mean it!” — what exactly is the solution? (and clearly, if wall street “has a saying”, then wall street doesn’t expect a “solution” to come anytime soon!)

    i’m fascinated by the condition of modern democratic discourse. everyone has a problem diagnosis. everyone thinks the solution is simple, and has the solution. the solution always imposes costs on someone else, who has a different solution. the solutions must be adjudicated, or legislated, or regulated, or administrated, which means the solution bastard will end up being constipated and dissipated. and for the dissipated constipation there will be simple solutions. and so the churn of simple solutions boils eternal.

    baby jesus needs to come down and kick some ass.

  8. Mike in Nola says:

    Thanks for the post, Chris.

    LSU and other state universities are only considered not top tier because they don’t contribute so many star witnesses to Congressional investigations. Those who train players for the fraud factories can’t afford to be honest about those future employers.

  9. Cursive says:

    @Mike

    Agreed. Joe Kernan graduated from MIT. ‘Nuff said.

  10. Mike in Nola says:

    Even better: Ben Bernanke went to Harvard undergrad and has his Ph.D. from MIT. Even more ‘Nuff said.

  11. fonzanoons says:

    I tried to get cards for our company after I received this notice. US Bank wanted FOUR to SIX weeks!!! Advanta’s conduct is deplorable. They’re punishing the few businesses managing to stay afloat by pulling the rug out from under us.

    I found Comdata and they’ll be sending us cards next week. I’ll have feedback in another week or so. I’d be interested to know what others are using.

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