It gives a basic idea of securitizing receivables

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Debt in Disguise
The boundaries between receivables securitizations and loans are blurring.
Vincent Ryan, CFO Magazine
November 1, 2007
Why does WESCO International Inc. use accounts-receivables securitization, a form of financing so
closely linked to the subprime-mortgage meltdown? "Because we can," says senior vice president and
CFO Stephen Van Oss.
Van Oss is speaking only partly tongue-in-cheek. His company, a $5.3 billion distributor of electrical
products, has a high-quality customer base and a robust IT platform for tracking the performance of
receivables, capabilities demanded by banks and credit-rating agencies.
But securitization is also cheap. "It's 60 to 80 basis points better pricing than any other asset-based
program," he says. "It's the most efficient way to borrow money."
Indeed, low cost is a key reason all forms of asset-backed securitization (ABS) have flourished (see
"What Lies Beneath" at the end of this article), reaching $1.2 trillion in outstanding issues of asset-
backed commercial paper last July. That's up 83 percent in three years, according to the Securities
Industry and Financial Markets Association (SIFMA). The "other" category of outstanding asset-backed
securities, which includes corporate trade receivables, has also grown, to $993 billion as of second-
quarter 2007. That $993 billion was more than the dollar amount of securities backed by credit-card
receivables and home-equity loans combined, according to SIFMA.
The other advantage to ABS is that, unlike a loan, a corporation does not have to record it as debt.
Securitization allows companies to transfer their trade receivables to a special-purpose entity, isolating
them from the risks generally associated with the company. Accordingly, the SPE can raise money in
the capital markets at a lower price than the company could directly because the SPE can garner a
higher credit rating than the company as a whole (see "Anatomy of a Typical Securitization" at the end
of this article).
In light of the crisis in subprime mortgages, however, securitization doesn't seem as clever as it once
did. "The subprime mess reminds the market that it matters what you securitize," says Adrian Katz,
CEO of Finacity, an asset-backed financing company. "A securitization is ultimately only as good as the
'security', the collateral."
From a corporate perspective, another problem is that securitization vehicles may not be as safely off
the balance sheet as they seem. The legal structure has not been battle-tested in the courts, lawyers
admit. Employees may inadvertently cross invisible legal boundaries and invalidate these structures
altogether. Some companies, WESCO among them, are putting them back on the balance sheet. That,
in turn, reinforces the notion that receivables securitization is, in many ways, a secured bank loan in
disguise — and a loan to a company that may be nowhere near investment-grade.
"What interests me is how this product got so big, when its legal underpinnings are arguably shaky,"
says Ken Kettering, an associate professor at New York Law School.
Speculative-Grade Roots
To date, no one has claimed that trade-receivables securities are as flawed as those backed by
subprime mortgages. Most securitization agreements come with representations and warranties that
protect the cash flow, as well as credit enhancements like "overcollateralization," the posting of more
collateral than is needed to obtain financing.
In addition, "because the underlying assets have a short duration (30 to 45 days), trade receivables
don't pose the same price volatility [risk] as a 30-year mortgage," says Katz. "The marked-to-market
type calls don't happen in trade receivables."

2. Still, part of what backs the commercial paper bought as triple-A credits are receivables from
companies that are junk or near-junk credits. For example, in 2003, with the help of Finacity, Sprint
Canada secured a five-year deal to sell its receivables to National Bank of Canada's commercial-paper
conduit. Although the deal was A-rated, at the time Sprint Canada had senior secured notes deep in
speculative-grade territory. Similarly, Finacity helped create a $55 million program last year for
Alliance One International, a single-B leaf-tobacco merchant, many of whose customers operate in
emerging markets.
Because the company that originates the receivables is still collecting the payments, servicing risk is a
concern in these deals, Katz admits. Indeed, Finacity "buttresses" the servicing capabilities of its
clients, he says, which tend to have less-robust systems than companies like WESCO. Finacity sets up
the SPE, collects on the accounts, monitors the creditworthiness of debtors, and reports daily on
receivables performance.
But even Katz says, "Receivables are very gritty and lots of things can happen — partial payments,
delayed payments, totally disputed payments. A lot depends on the operational abilities of the seller."
And on the judgment of the rating agencies. The purpose of securitization is to make the credit rating
of the company practically irrelevant in a financing, so that even in a bankruptcy the receivables cash
flow will be protected. The companies originating the securitization need the triple-A or near-triple-A
stamp.
In addition to the rating of the originating company (if available), rating agencies examine the credit
and collection policies of the company, as well as debtor concentration in the receivables pool and the
performance record of receivables, says Ravi Gupta, a senior director in Fitch's ABS group. Triggers
that protect against dramatic declines in receivables performance — like those that set maximum
limits for defaults, dilutions, and delinquencies — are also factored in.
But in reality, rating agencies rely more on risk mitigants such as liquidity lines from appropriately
rated banks, and credit enhancements such as letters of credit. In a 2005 report, Fitch said that it
"...places little or no reliance on the originator's ability to meet its obligations if its [credit] rating is
below that of the issued debt."
The rating agencies also rely greatly on legal constructs that say the payment stream to investors will
not be hindered. For instance, the transfer of receivables to the SPE must be a "true sale." That is, the
seller must not retain too much of the reward or the risk coming from the asset, says Robert Hahn, a
partner with Hunton & Williams LLP. In addition, the SPE has to be "nonrecourse" — in other words,
the company's creditors must not have claim to the assets of the SPE if the originating company goes
bankrupt.
"Securitization divorces the creditworthiness of the [company] from the credit of the pool," says Mark
Spradling, a partner with Vinson & Elkings LLP. "True sale and nonconsolidation are part of that
separation."
But the opinion that legal control of receivables has passed to a third party has not been litigated in
the bankruptcy courts. When LTV Steel declared bankruptcy in 2000, it filed for access to securitized
receivables, arguing that its securitizations were "disguised financings." When a court agreed to hear
LTV's arguments, stunned lenders quickly arranged debtor-in-possession financing for the company —
provided it dropped its claims to the receivables. As a result, the issue has never been resolved in the
courts.
"There's no bright-line test," says Spradling.
Crossing a Fine Line
The delicate structure of securitizations is evident in the experiences of companies that have —
sometimes accidentally — pierced the legal bubble on which this form of financing depends. Aspen
Technology, a provider of process-optimization software, was forced to restate its financials going
back to 2005 because it inadvertently violated the true-sale structure of its securitization. Salespeople
at the company did so by licensing additional software to customers and consolidating the remaining
balance of older installment receivables into the new contracts. The securitization agreement did not

3. allow that in most cases. As a result, Aspen unintentionally regained control of some securitized
receivables and was forced to alter its balance sheet.
It also is relatively easy for a company to cross the nonrecourse boundary on purpose. At $2.3 billion
Volt Information Sciences, a staffing firm that has a $200 million securitization program, a customer
with a large receivable whose debt was in the company's securitized pool filed for bankruptcy last
summer.
"Technically, it was not mine to do anything with," says Volt senior vice president and treasurer
Ludwig Guarino, speaking of the debt. But when a debt buyer was willing to pony up 90 cents on the
dollar, Guarino got Mellon Bank N.A., sponsor of the commercial-paper conduit into which Volt sells its
receivables, to give Guarino a release on the lien. "The cash goes into the SPE, just like any other
cash collection," Guarino says.
Not all banks would have allowed such an arrangement. A key question in true-sale opinions is, after
all, "Is there recourse back to the seller on failure of performance of the asset? The more recourse
there is back to the seller, the less it looks like a sale and the more it looks like a loan," Spradling
says. This, of course, was why many mortgage originators were reluctant to help struggling
homeowners rework the terms of their loans this past summer.
In July, under pressure from Congress, the Securities and Exchange Commission gave subprime-
mortgage lenders permission to modify already-securitized home loans — if a default seemed likely —
without taking the assets back on their balance sheets. The impact that guidance might have on other
securitizations simply was not discussed. But clearly, the ability of corporations to deal with debt that
has been securitized is turning into more of a gray area.
Accounting Calls It Debt
Technically, according to Financial Accounting Standard No. 140, SPEs in securitizations qualify for off-
balance-sheet treatment. But some corporations that securitize receivables, desiring to bring financial
reporting in line with economic reality, are bringing them back on balance sheet and calling them
debt. On-balance-sheet treatment, though, removes one of the prime advantages of securitization —
raising capital without increasing the company's leverage.
In December 2006, WESCO amended the accounting treatment of its $500 million securitization
program by including receivables sold on its balance sheet and labeling them secured borrowings. The
receivables showed up as short-term debt, instead of just appearing in a note to accounts receivable,
and the costs of the securitization appeared on the interest expense line.
"We did it primarily for transparency and good governance. It has made it a lot easier for people to
understand, and we don't have to do reconciliation between GAAP and non-GAAP," says Van Oss. "It
had no impact on the economics." The rating agencies did not downgrade the transaction nor did the
commercial-paper conduit ask for more collateral to reflect the new treatment. Dean Foods, a $10
billion dairy-products maker, handles its securitization similarly, consolidating the assets of three
SPEs. Volt does also.
"Professionals — debt analysts, bankers, and equity analysts — all add [receivables] securitizations
back onto the balance sheet in figuring leverage and debt ratios," says Bob Finley, managing director
of Fifth Third Bank's asset-securitization business. "It's window dressing at best. Let's just call it debt."
Blowback from the era of Enron is one reason companies are tinkering with the accounting. More often
than not, though, non-investment-grade companies still want to be able to handle securitizations off
balance sheet, says Finacity's Katz, adding that the companies that move securitization back on the
balance sheet "are the companies that have the luxury of taking the high road."
Too Big to Fail?
Securitization is definitely in the sights of banking regulators. In the wake of last summer's credit-
markets crisis, the International Monetary Fund warned banking regulators not to stifle the "enormous
benefits" from financial innovation. But the IMF did call for a review of the different models by which
banks pass on credit risk to investors. It also suggested that the rating agencies use different ratings
for structured products and regular corporate debt.

4. If securitization were to go away or be drastically curtailed, says Van Oss, WESCO would just shift its
debt to its slightly more expensive asset-based revolver.
But even securitization's detractors admit it is probably here to stay. In the judgment of New York
Law's Kettering, this form of structured finance is too big to fail. If there were ever a ruling in the
bankruptcy courts that nullified the structures of true sale and bankruptcy-remote SPEs, the rating
agencies would have to downgrade all trade-receivables securitizations to the credit quality of the
originators, he says.
"A court aware of the stakes is very unlikely to make such a ruling," says Kettering, "and should that
event occur, Congress would bail out the product."
Vincent Ryan is a senior editor at CFO.
What Lies Beneath
Calculating the Cost of Securitization
Tapping the capital markets without a lending bank in between means that even non-investment-
grade companies can finance at near what triple-A companies pay.
The "weighted average pool rate" that bank conduits charge to buy receivables is calculated on a daily
basis and includes an agreed-upon margin on top of the rate the bank pays.
Short-term rates rose as high as 6 percent during last summer's credit crunch, as bank conduits could
not issue paper for longer than overnight, says William Rutkowski, a vice president in Wachovia
Corp.'s conduit-securitization group. But after the Federal Reserve Board cut rates, banks issued paper
with longer maturities, dropping commercial-paper rates to below 5 percent.
In the past year, the cost of funds for securitization programs has started at 5.3 percent. However, in
some securitization agreements, if the conduit cannot move its commercial paper, the rate passed
through to the originator climbs to the prime rate or even LIBOR plus a set spread. If a portion of the
receivables securitization facility is unused, the originating company may also have to pay a program
fee on that unused amount ranging from 100 to 400 basis points.
CFOs also have to consider the costs of credit enhancement as well as those for the services of
lawyers and investment bankers. For example, to ensure investors will not suffer losses from delayed
collections or defaults, the originator must sell to the special-purpose entity a level of receivables in
excess of the amount needed to pay for the securities issued. In most cases, "true-sale" treatment
requires that any residual value from this "overcollateralization" not be available to the originator.
For some companies, information-systems costs could be the highest hurdle. Without an upgrade, a
company's current systems may not be able to handle the ongoing and historical analysis of
delinquency statistics, dilution figures, and breakdowns of customer concentrations that rating
agencies and bank conduits demand. — V.R.

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