Introduction to Securitization, Second Edition
“Securitization” stands for the massive movement since the 1970s to transform illiquid debt into securities. It is the conversion of third party obligations into tradable securities. When called “structured financing,” it described securitization by corporate borrowers of their own obligations or their financial assets. “Securities” and “debts” have much in common; both are obligations by one party to pay another, and both can be viewed as evidence of money claims. However, debts are less amenable to trading than are securities. Markets, including securities markets, require standard forms and terms rather than “custom-made” instruments, a sufficient number of instruments in denominations that facilitate trading and relatively low-cost information about the borrowers. Bonds have these attributes. Debts lack these attributes. Parties to debt and securities are even described by different words.
Securitization has grown enormously. By the end of 1989, approximately $900 billion in mortgage-backed securities were outstanding. By the end of 1991 the amount grew to approximately $4 trillion. In 1996, publicly-registered issues of asset-backed securities yielded $156 billion, up 41% from 1995’s $110 billion. The variety of securitized loans is enormous: commercial real estate loans, single-family mortgages, debts of bankrupt companies, auto and light truck loans, credit card loans and other receivables (including health care and pharmaceutical receivables, license and franchise fee receivables, airline ticket, hotel and other travel receivables, tax receivables) and trade credits, equipment and automobile leases, taxi-cab medallions, computer leases, municipal leases, bad debts resulting from defaults by credit card debtors and junk bond issuers, student loans, cosmetic surgery receivables, servicing rights, tax liens, loans made and held by the federal Government, royalties generated by performing celebrities, natural resource assets, mutual fund shares, athletic venue revenues, state indebtedness to finance easement acquisition, software financing obligations and insurance premium loans.
Securitization involves instruments, transactions, institutions, and markets. There are many legal problems that this process raises, touching almost all branches of the law. The legal problems rise from the three innovations presented by securitization. (1) The legal metamorphosis of instruments from loans (contracts) to securities (personal property); (2) The creation of additional intermediaries: the SPVs that issue asset-backed securities. (3) The process, which combines institutional with market intermediation.
Like it or not, definitions and classifications are crucial to legal coherence. Classifications are necessary to organize the vast legal material. The human mind is incapable of retaining a large amount of detailed information. Also, classifications are important for legal analysis by pointing to the book of rules. Choosing one definition or class rather than another can lead to different legal outcomes. In addition, classifications provide predictability, important in business law. The important questions are: under what circumstances should we reclassify and redefine, and which institution should perform the task?
Securitization requires a reclassification from contract (loans) to property (securities). Contract, property, and markets are the building blocks of an economic and business order. It is assumed that property and contract laws are compatible. But a closer examination of current law shows that they are not compatible today. If it is desirable to create markets, important contract law policies must give way to conflicting policies underlying property law.
Contract and property categories are shaped by different policies. Subject to exceptions: (1) The underlying policy in contract law is that personal relations should be fostered. The starting point is that contractual relationships are personal and not transferable without the consent of the other party. (2) The parties are essentially free to design their relationships as they wish and may keep their contract relationship confidential.
Today, property law is based on the policy of facilitating market transactions. Therefore, (1) property should be transferable and the parties cannot usually limit the transfer of property (with exceptions). (2) Transfers of some kinds of property, such as real estate, should be made a matter of public record. (3) Parties may not create different property rights (to avoid confusion). To the extent possible, buyers should know what they are buying.
Policies underlying contract and property show sharp conflicts. If property must be transferable, interpersonal relationships cannot always be preserved. If the transfer must be publicized, and the form of transfer and the contents of transferable rights are standardized, the freedom of the parties to design the terms of their arrangement is curtailed. This conflict does not mean that these classifications are mutually exclusive. Property and contract law overlap: parties contract for the sale or lease of property. However, when contract and property overlap and their underlying policies conflict, one classification must have priority over the other.
In some respects, securitization is not unique. America is constantly “propertizing” contractual arrangements and creating markets for them. Therefore we ought to prepare for transitions from contract to property at the lowest cost and friction. This task should not be left to the courts: legislators, regulators, codifiers of uniform laws must step in; lawyers, law teachers and scholars can also lend a hand.