Securitization is a financial technique that converts illiquid assets, such as loans or accounts receivable, into tradable securities. While this practice is routine for high-quality assets like residential mortgages or credit card debt, the securitization of defaulted dept is a much more specialized and less common endeavour.
Why Securitize Defaulted Obligations?
The main purpose of securitizing a portfolio of defaulted debt is to enable its professional recovery and management. A dept in default is a non-performing asset; it fails to generate interest, and its actual value is uncertain. The original creditor holding such a dept might lack the specific resources, expertise, or time to pursue recovery, a process that can involve intricate negotiation, litigation, and tracing assets.
By securitizing these defaulted obligations, the original creditor can transfer the recovery risks and administrative burdens to a special purpose vehicle (SPV). This SPV then issues securities to investors who are motivated by the potential for a high return from the successful collection of the underlying debt. This mechanism allows the specialized function of debt recovery to be concentrated under a single management entity, often handled by professionals such as litigation funds, debt collection agencies, or law firms.
Two Main Securitization Formulas
All such securitizations are unique and highly customized, but they can be broadly categorized into two models:
- Recovery-Funded Split: The defaulted depts are assigned to the SPV, and investors are asked to contribute only the funds needed to finance the recovery efforts. The proceeds from the recovery are then split between the original creditor and the investors (the holders of the SPV’s securities).
- Discounted Sale: This model is mainly used for defaulted dept of companies that aren’t facing immediate bankruptcy. The defaulted dept is “sold” to investors via the SPV at a significant discount. For example, a debtor might owe $10,000,000, and the creditor may be willing to offload the obligation for $2,000,000. The investors purchase the SPV’s securities, which are backed by this obligation, for the discounted amount (say, $2 million, plus a provision for recovery costs). The $2 million goes immediately to the original creditor. The investors are essentially taking a risk that the professional management of the recovery will yield significantly more than the $2 million they paid.
A variation of these models involves the securitization of debts belonging to an already bankrupt entity. In such cases, both variants are possible: the transfer of the debt to the SPV to fund the recovery effort, or the sale of the debt to the SPV using money raised from investors.
Benefits for Creditors and Investors
Securitization of defaulted obligations provides several advantages for both the investors and the original creditor:
- Liquidity: In the discounted sale scenario (Formula 2), the original creditor gains a way to convert an illiquid, non-performing asset into cash, even if at a loss, which improves their balance sheet and frees up capital.
- Professional Management: In the recovery-funded split scenario (Formula 1, where the creditor gets no cash upfront), the original creditor benefits from a professional recovery team working to eventually liquidate the defaulted debt without having to personally finance the effort.
- Capital Efficiency: It allows investors with a high tolerance for risk and a focus on distressed assets to engage in a structured investment, potentially achieving substantial returns if the recovery efforts are successful.
This entire process fundamentally differs from typical asset-backed securitization, which aims to create a diversified pool of performing dept with predictable cash flows and separate it into risk tranches. Securitization of defaulted dept involves a homogenous pool of distressed assets where the primary driver of value is the efficiency of the recovery process, not predictable interest payments.
Instruments Used for Securitization
Securitizing defaulted debt is a highly customized procedure, almost always resulting in bespoke and privately placed securities. The most commonly used instruments are:
- Loan Participation Notes (LPNs): These are debt securities representing a beneficial interest in a single loan or portfolio of loans. Investors in LPNs receive payments that correlate with the cash flows generated by the underlying loan recoveries.
- Asset-Backed Notes: Similar to LPNs, these securities have payments explicitly tied to the recovery performance of a specific pool of assets, which, in this context, is the defaulted dept.
- Recovery Notes: This is essentially a marketing term for securities backed by an already non-performing obligation. Read our article about this instrument here.
- Private Investment Funds: An alternative to issuing notes is to establish a private investment fund (like a limited partnership) to acquire the defaulted debt. Investors become shareholders or partners, and their returns are based on the fund’s overall recovery performance.
Financing the Recovery
The legal and operational framework of these instruments is meticulously designed to address the specific challenges of the bad debt. Since defaulted debt usually yields no interest, the SPV must have an independent cash source to finance the recovery process, which can be costly. This is often addressed at the beginning, for instance, by having a litigation fund sponsor the arrangement. The litigation fund agrees to cover all recovery costs, such as court expenses and legal fees, and is then compensated from the recovered proceeds. This arrangement aligns the recovery agent’s incentives with the investors’ goal of maximizing returns.
Although privately placed securities generally don’t require active trading, it is often useful to have them entered into global clearing systems like Euroclear or Clearstream for easier settlement. We can arrange this if required.
Shariah-Compliant Securitization (Sukuk)
Restructuring the securitization of interest-bearing debt into Shariah-compliant securities (sukuk) is an exceptionally intricate and rare undertaking. The fundamental hurdle is the Shariah principle that prohibits lending for interest (riba) and deems it an unacceptable practice (haram).
To address this, several structural and doctrinal issues must be resolved:
- The underlying debt must be converted into a non-interest-bearing arrangement. This often necessitates the cooperation of the original debtor, who must agree to a new, Shariah-compliant repayment structure.
- The debtor’s business must comply with Shariah principles. For example, a loan to a company involved in alcohol production or a conventional bank cannot be securitized into sukuk.
- A doctrinal issue in Shariah law concerning the assignment of debt must also be carefully navigated.
Due to these complexities, the securitization of conventional, interest-bearing debt into sukuk is exceptionally rare. The legal and theological requirements make this a highly specialized area, frequently demanding bespoke solutions that adhere to the ethical and legal frameworks of Islamic finance.
To sum up: securitization of bad loans is a highly specialized financial tool used to transform non-performing assets into a structured investment. It meets a crucial need for professional management and recovery of defaulted debt, providing liquidity to the original creditors and opportunities for specialized investors.
Tiner Wernow (formerly John Tiner & Partners) designs and creates securities and other financial instruments that help clients raise capital, sell managed trading strategies, and securitize various assets.
We offer a complete, full-cycle service, from developing the initial structuring concept to its full implementation, which includes acquiring an International Securities Identification Number (ISIN), handling issuance, global clearing, exchange listings, and placement routes. We can transform any asset or investment idea into an easily tradable and globally cleared security.
Our global services platform, 208Markets, provides issuance, brokerage, and SPV maintenance services across multiple jurisdictions.
Additionally, we’ve created educational materials under the “Tiner Educational Hub” to help professionals understand the securitization tools available to achieve their business objectives more efficiently.
