DIPs Can’t Afford to Take a Bath

An article by Anousha Sakoui and Nicole Bullock in Financial Times entitled “Liquidation risk grows as DIP finance dries up” is one more piece of evidence that hybrid systems don’t work.

I’m referring here to the two corporate bankruptcy systems the U.S. has put in place: one designed to help companies get back on their feet at the point of insolvency, and one with the right specifications to help companies get back on their feet before they reach the point of insolvency.

The official bankruptcy system came into existence as a result of the railroad funding crisis in the third quarter of the nineteenth century, when the U.S. broke with U.K. tradition and allowed bankruptcy courts to work with creditors to restructure companies back into health. In such situations, specialty lenders come in, take a lien on the assets of the company (the Debtor-in-Possession assets) and manage it tightly out of insolvency under a set of controls that resemble a securitization bond indenture (Debtor-in-Possession financing). The second informal system, of course, is securitization itself, the emergence of which is associated with the savings and loan crisis in the third quarter of the twentieth century.

Securitization is a de facto restructuring tool, although it has rarely been used strategically as such. On the contrary, securitization appears to have been used by well-known public companies to do the opposite: put themselves into bankruptcy by cashing out the resources of the company and wasting the proceeds or arrogating them to the corporate office. This was possible because of loopholes in the accounting system and an orchestrated willfulness in the market to turn a blind eye to a serious information problem in the securitization sector.

I can’t prove that securitization is a forward-looking solution to bankruptcy, or that it is a better fit for financing corporations under a so-called lifecycle model, as I have argued elsewhere, but the logic is obvious. Securitization supplies the investor with more precise information on asset quality than the accounting model (when it isn’t compromised by bad ratings), and this is a boon to small companies that deliver value but lack brand. It also, in theory, gives greater flexibility to branded companies who are locked into doing the same thing — to a large extent by their creditors and shareholders, who don’t want to bear the risk of change.

GM and its funding arm GMAC are a perfect example of a large public company that should not have used securitization for working capital but could have used it to transform and modernize its operations. The total bailout package to GM and GMAC was something under $20.8 billion, but has anyone bothered to tally how much capital GM raised off balance sheet under the combined auspices of GMAC and RFC in the years leading up to the crisis, or tried to figure out where it went? Senior management appears to have plundered the resources of the company, leaving the tough management decisions for President Obama to make by regulatory fiat. Is it any wonder that a DIP lender would have second thoughts about investing debt capital in the residual value of an insolvent company today?

— Ann Rutledge