A New York bankruptcy judge's ruling has thrown into question one of the sacrosanct assumptions of securitization — that principal and interest payments resold to investors are off-limits to the bond issuer's other creditors.

The subject has cropped up several times in the General Growth Properties Inc. bankruptcy, much to the annoyance of the judge overseeing the case. How this issue was resolved promises to stimulate debate among participants in the $720 billion market for commercial mortgage-backed securities.

General Growth, a Chicago real estate investment trust, specializes in malls such as Boston's Faneuil Hall and New York's South Street Seaport. The company, started in the early 1950s, filed for bankruptcy protection on April 16 in federal Bankruptcy Court in New York. With 200 malls in 44 states, General Growth had just over $29 billion of assets and $27 billion in liabilities late last year.

The mall giant routinely borrowed to buy and refinance properties. This debt was resold through securitization to a wide range of investors, among them insurers, mutual funds and pension funds. General Growth debt has been repackaged into $14 billion of CMBS, a significant chunk of this market.

Investors holding bonds that included mortgages for General Growth properties always believed that loan payments made each month to special-purpose entities and passed on to them were immune to a bankruptcy filing. It is an assumption that has been generally accepted by all participants in the roughly two decades of the CMBS market's existence.

This month, however, Judge Allan Gropper ruled that special-purpose entities for 100 loans resold into CMBS could be included in the parent's bankruptcy.

"The fundamental protections … that the SPE structure represents are still in place and will remain in place during the Chapter 11 cases," Judge Gropper wrote in his 41-page opinion.

He added that, though SPEs were created to guard against substantive consolidation — that is, being scooped up into the issuer's bankruptcy case — the "question of substantive consolidation is entirely different from the issue whether the board of a debtor that is part of a corporate group can consider the interests of the group along with the interest of the individual debtor when making a decision to file a bankruptcy case."

There was little surprise when news of the judge's ruling filtered through the market, analysts said.

"He has been very debtor-friendly. At this point no one expected him to change his mind," said Lisa Pendergast, the head of CMBS research at Jefferies & Co.

Still, the judge's decision "is a clarion and so far perhaps the only judicial pronouncement on the bankruptcy relationship between parent and structured finance subsidiary," Moody's Investors Service Inc. warned in a note to investors this month.

According to the rating agency, bankruptcy courts will "retain their prerogatives as a refuge of redemption for debtors, and structured finance will have to try to structure around this rubric."

Bond investors will have to become better versed in the workings of bankruptcy court, analysts said.

"CMBS were supposed to be bankruptcy-remote and not bankruptcy-proof," said Darrell Wheeler, the head of CMBS research at Citigroup Inc. The General Growth case will spur bankers to look for ways to improve the bankruptcy-remoteness of securitizations, he said.

"Belts and suspenders may be added," Wheeler said. "They'll never succeed [in making] them 100% bankruptcy-proof."

Bradley Ritter, a partner in Paul, Hastings, Janofsky & Walker LLP, said the case highlights the fact that bankruptcy-remote is not the same as bankruptcy-proof and that this could quickly have a "chilling effect" on commercial real estate finance.

"It certainly won't" give lenders incentives to lend, he said, predicting that borrowing costs will rise.

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