Securitization is a financial process that transforms illiquid assets, such as loans or receivables, into marketable securities. While this practice is common for high-quality assets like residential mortgages and credit card debt, the securitization of bad loans, specifically those already in default, is a much more specialized and less common activity.

Why Securitize Bad Loans?

The primary reason to securitize a portfolio of defaulted obligations is to facilitate their professional management and recovery. A defaulted loan is a non-performing asset; it is not generating interest, and its value is uncertain. A creditor holding such a loan may lack the specialized expertise, resources, or time to pursue recovery efforts, which can involve complex litigation, negotiation, and asset tracing.

By securitizing these bad loans, the original creditor can transfer the risks and burdens of recovery to a special purpose vehicle (SPV). The SPV, in turn, issues securities to investors who are willing to pursue a potentially high return from the successful recovery of the underlying debt. This structure allows for the concentration of a specialized function – debt recovery – under a single management umbrella, often in the hands of professionals like litigation funds, law firms or debt collection agencies.

All such securitizations are bespoke; nevertheless, they can be roughly broken into two categories. One formula is to have the bad loan(s) assigned to the SPV and call on investors to contribute only the money needed to fund the recovery, promising then to split the recovery proceeds between them (the holders of SPV’s securities) and the original creditor. The other formula – and it works mainly for securitizing defaulted loans of companies not facing an immediate bankruptcy – is to “sell” the bad loans to the investors via the SPV at a discount. Say, the debtor owes 10,000,000$ to the creditor, and the creditor is willing to offload this obligation for 2,000,000$, a huge discount. The investors then buy the SPV’s securities backed by this obligation for 2 million (plus, maybe a provision for the recovery costs), the 2 million immediately going to the original creditor. The investors thereby gamble that well over 2 million will be recovered on that loan through professional management of the recovery.

Securitization of defaulted obligations offers a number of benefits to the original creditor and to the investors:

• Liquidity: In scenario 2 above it provides the original creditor with a means to convert an illiquid, non-performing asset into cash (albeit, at a discount), improving their balance sheet and freeing up capital.
• Professional Management: In scenario 1 (the creditor gets nothing upfront) it gives to the original creditor the benefit of engaging a professional recovery team to eventually liquidate the bad obligation, without having to pay for the effort.
• Capital Efficiency: It allows investors with a high-risk tolerance and a focus on distressed assets to participate in a structured investment, potentially achieving significant returns if the recovery efforts are successful.

This process is fundamentally different from typical asset-backed securitization, which focuses on creating a diversified pool of performing loans and tranching them based on risk. Securitization of bad loans deals with a homogenous pool of distressed assets, where the primary value driver is the efficiency of the recovery process, not the predictable cash flow from interest payments.

A variation of the securitization scenarios outlined above is the securitization of debts of an already bankrupt entity. Both variants – the sale of the debt to the SPV for the money raised from investors, and the transfer of the debt to the SPV to seek funding of the recovery effort – are possible.

How is it Done? The Instruments

Securitizing defaulted debt is a highly customized process, almost always resulting in bespoke and privately placed securities. The most common instruments used for this purpose include:

• Loan Participation Notes (LPNs): These are debt securities that represent a beneficial interest in an underlying loan or portfolio of loans. The investors in LPNs receive payments based on the cash flows generated by the underlying loan recoveries.
• Asset-Backed Notes: Similar to LPNs, these are securities whose payments are explicitly tied to the performance of a specific pool of assets – in this case, defaulted loans.
• Recovery Notes: this is just a marketing variation of a name for securities where the underlying asset is an already non-performing obligation.
• Private Investment Funds: A common alternative to issuing notes is to create a private investment fund (e.g., a limited partnership) that acquires the defaulted debt. Investors become partners or shareholders in the fund, and their returns are based on the fund’s overall recovery performance.

The legal and operational structure of these instruments is carefully crafted to address the unique challenges of the specific bad debt. Since a defaulted debt typically pays no interest, the SPV holding it needs an independent source of cash to finance the recovery process, which can be costly. This issue is often addressed at the outset, for instance, by having a litigation fund sponsor the arrangement. The litigation fund agrees to cover all recovery costs, such as legal fees and court expenses, and is then remunerated from the recovered proceeds. This aligns the incentives of the recovery agent with the investors’ goal of maximizing returns.

While privately placed securities generally do not require active trading, it is always beneficial to have them entered into global clearing systems such as Euroclear or Clearstream for ease of settlement. We can arrange for this to be done, should it be required.

Shariah-Compliant Securitization

Structuring the securitization of interest-bearing debt into Shariah-compliant securities (sukuk) is a particularly intricate and rare undertaking. The core challenge lies in the principles of Shariah, which prohibit lending for interest (riba) and deem it an unacceptable practice (haram).

To address this, a number of doctrinal and structural issues must be overcome:

• The underlying debt must be converted into a non-interest-bearing arrangement. This often requires the cooperation of the original debtor, who must agree to a new, Shariah-compliant repayment structure.
• The debtor’s business itself must not violate Shariah principles. For example, a loan to a company involved in alcohol production or a conventional bank would be considered un-securitizable into sukuk.
• A doctrinal issue in Shariah law, which may prohibit 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 it a highly specialized field, often requiring bespoke solutions that align with the ethical and legal frameworks of Islamic finance.