Securitization is a financial technique used to convert assets that are not easily bought or sold, such as loans or receivables, into transferable securities. While this method is standard for high-quality assets like residential mortgages and credit card debt, applying it to bad dept, specifically that which is already in default, is a much more specialized and less frequent activity.
The Rationale for Securitizing Bad Dept
The main objective for securitizing a portfolio of defaulted financial obligations is to enable their professional management and ultimate recovery. A defaulted dept is a non-performing asset; it neither generates interest nor has a certain value. A creditor holding such a dept may not have the necessary expertise, resources, or time required for recovery efforts, which can involve complex negotiation, legal action, and asset tracing.
By securitizing these defaulted debts, the original creditor can transfer the risks and responsibility for recovery to a special purpose vehicle (SPV). The SPV then issues securities to investors who are motivated by the potential for high returns from successfully recovering the underlying debt. This structure allows the specialized function of debt recovery to be centralized under a single management entity, often professionals like debt collection agencies, law firms, or litigation funds.
Two Main Securitization Formulas
Although all such securitizations are unique (bespoke), they generally fall into two broad categories:
- Recovery-Funded Split: The bad dept is assigned to the SPV, and investors are asked to contribute only the funds needed to finance the recovery efforts. The recovery proceeds are then split between the original creditor and the investors (the holders of the SPV’s securities).
- Discounted Sale: This method is primarily used for defaulted dept owed by companies that are not immediately facing bankruptcy. The bad dept is “sold” to investors via the SPV at a significant discount. For instance, if a debtor owes $10,000,000, the creditor might be willing to sell the obligation for $2,000,000. The investors purchase the SPV’s securities backed by this debt for the $2 million (plus a possible provision for recovery costs), and the $2 million goes immediately to the original creditor. The investors take a calculated risk, betting that professional management of the recovery will yield substantially more than the $2 million they paid.
A variation of these scenarios involves securitizing the debts of an entity that is already bankrupt. In such cases, both the discounted debt sale to the SPV and the transfer of debt to the SPV to fund a recovery effort are viable options.
Benefits of Securitizing Defaulted Obligations
Securitizing defaulted debt provides several advantages for both the original creditor and the investors:
- Liquidity: In the discounted sale scenario (Formula 2), the original creditor gains a way to convert a non-performing, illiquid asset into immediate cash, which enhances their balance sheet and frees up capital.
- Professional Management: In the recovery-funded split scenario (Formula 1, where the creditor receives no money upfront), the original creditor benefits from a professional recovery team working to liquidate the bad obligation without having to cover the cost of the effort.
- Capital Efficiency: It offers investors with a high tolerance for risk and a focus on distressed assets an opportunity to participate in a structured investment, potentially achieving significant returns if the recovery efforts are successful.
This process differs fundamentally from typical asset-backed securitization, which focuses on creating diversified pools of performing dept and rating it based on risk. Securitization of bad dept involves a homogenous pool of distressed assets, where success is driven by the efficiency of the recovery process, rather than the predictable cash flow from interest payments.
The Instruments Used
The securitization of defaulted debt is highly customized, nearly always resulting in bespoke and privately placed securities. The most common instruments include:
- Loan Participation Notes (LPNs): These are debt securities representing a beneficial stake in an underlying loan or portfolio of loans. Payments to LPN investors are based on the cash flows generated from the dept recoveries.
- Asset-Backed Notes: Similar to LPNs, the payments from these securities are explicitly linked to the performance of a specific pool of assets, in this case, defaulted dept.
- Recovery Notes: This is essentially a marketing term for securities whose underlying asset is an already non-performing obligation. Click here to read our prior article on the subject.
- Private Investment Funds: A common alternative to issuing notes is establishing a private investment fund (e.g., a limited partnership) that acquires the defaulted debt. Investors become partners or shareholders, and their returns are tied to the fund’s overall recovery performance.
Since defaulted debt typically pays no interest, the SPV must secure an independent source of cash to cover the often-costly recovery process. This is frequently addressed at the outset, for example, 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 later paid from the recovered proceeds. This arrangement ensures the recovery agent’s incentives align with the investors’ goal of maximizing returns.
While privately placed securities generally don’t require frequent trading, their inclusion in global clearing systems like Clearstream or Euroclear is beneficial for simplifying settlement. We can arrange this should it be required.
The Complexity of Shariah-Compliant Securitization (Sukuk)
Restructuring the securitization of interest-bearing debt into Shariah-compliant securities (sukuk) is a particularly intricate and rare undertaking. The fundamental difficulty stems from Shariah principles, which forbid charging interest (riba) and deem it an unacceptable practice (haram).
To navigate this, several doctrinal and structural obstacles must be overcome:
- Conversion of Debt: The underlying debt must be restructured into a non-interest-bearing arrangement, often requiring the original debtor to agree to a new, Shariah-compliant repayment structure.
- Debtor’s Business Compliance: The debtor’s business activities must not violate Shariah principles. For instance, a loan to a conventional bank or a company involved in alcohol production could not be securitized into sukuk.
- Doctrinal Assignment Issues: A doctrinal issue in Shariah law, which may restrict the assignment of debt, must also be carefully managed.
Due to these complexities, the process of converting conventional, interest-bearing debt into sukuk is exceptionally rare. The unique legal and theological requirements necessitate highly specialized, bespoke solutions that fit within the legal and ethical frameworks of Islamic finance.
To summarise: the securitization of bad dept is a highly specialized financial tool that transforms non-performing assets into a structured investment. It meets the critical need for the professional management and recovery of defaulted debt, providing liquidity to the original lenders and investment opportunities for specialized investors.
Tiner Wernow, formerly John Tiner & Partners, designs and creates securities and other financial instruments. We help our clients raise capital, sell managed trading strategies, and securitize all types of assets.
We provide a complete service, from developing the initial structuring concept to its full implementation, which includes ISIN, issuance, global clearing, exchange listings, and placement routes. We help to package any asset or investing idea into easily tradable, globally cleared securities. We offer issuance, brokerage, and SPV maintenance services in various jurisdictions.
Our global services platform is 208Markets (https://208markets.com).
The educational materials found on the internet under the “Tiner Educational Hub” are intended to increase the awareness of professionals regarding the securitization tools available to help them more efficiently achieve their business objectives.
