A company is considering financing its A/R by issuing ABS. Management believes this will allow the company to increase credit sales and improve overall profitability and liquidity. In response, an analyst makes the following statement: “The company’s ABS are expected to receive a AAA-rating from the credit agencies.” The analyst’s statement about the credit agencie’s rating of the company’s ABS is most likely related to which of the following? A) profit margin B) Credit quality of the company C) Credit quality of the collateral This was from the CFAI problems end of reading 52 #30. The correct answer was C. But i chose B based on my logic: IF the company financed their own ABS, then the highest rating they could possibly have is their own rating. If the analyst says the company could receive a AAA rating, then the company must have such a rating also…Isn’t the whole point of issuing ABS through a SPV so a company can get the higher rating if their credit is lousy?? I thought it was only as strong as the weakest link, so although the collateral could be rosy, if it’s issued by the company, then as analyst’s we must assess the company backing the collateral??? Why is this logic off-base, i selected B based on this line of reasoning. Thanks
In my opinion, the company would be a weakest link only in case it gives guarantees for the underlying. If they just transfer A/R to SPV and SPV issues ABS, then the rating agencies will rate only the quality of the collateral.
An SPV issues the collateral and hence it is ‘detached’ from the company (TRUE SALE). This is the prime reason for issuing ABS in the first place (to enable a rating independent of the company rating) Thus for an SPV, only the quality of collateral (and credit enhancements) are taken into consideration for assigning rating. The Company is not held liable if collateral asset quality degenrates (only to the tune of liquidity and equity tranches it will PROBABLY be holding). Likewise if the Company defaults, the SPV is unaffected in terms of losing out of the collateral held by the SPV. The Company’s creditors cannot touch this collateral in the event of a bankruptcy. This enables the ABS to have a higher credit rating that the Company.
But in the problem, I assumed that the company is issuing the ABS. is this assumption not realistic, is it simply implied that the issuance of the ABS would be through an SPV?
It is not realistic, because the company will seek to find to cheapest source for this kind of financing. As EChai explained, by transferring A/R to SPV (or QSPV) it will be in position to gain better credit quality and, hence, issue an ABS with lower interest rate. However, further to EChai’s comments, I’m not sure that a SPV (not QSPV) would be considered bankrupcy remote… Anyone?
An ABS can only be serviced from the cashflows of the underlying assets. Hence, only the credit quality of the collateral is reflected in the credit rating. Suppose a company issues A/R ABS and the collateral value is declining due to suppliers going out of business. The Company however makes a windfall gain by selling off an asset (eg. building or other company investment). The investors in the ABS cannot utilise these cashflows (from sale of building) against A/R defaults by suppliers. Hence credit quality of collateral rather than credit quality of company is used for rating the ABS.
was reading this in the morning today - definitely says legal structure of ABS - includes the creation of SPV -> could be created so that the SPV is not included among corporate assets in case the firm goes bankrupt.
It is bankruptcy remote if the bankrupty in question is of the Company. The trustees of the SPV will ensure smooth operation of servicing the collateral (through appointed Servicer) and distributing the proceeds to the investors.
Thanks!