Securitizations and the financial crisis: Is accounting the missing link?

Abstract

In this paper we focus on the interplay between securitization accounting and regulatory capital rules to discuss how the misalignment between these two sets of regulations offered banks the opportunity to engage in opportunistic behaviors and incented them to take on too much risk.

Keywords:

• Securitization
• Financial crisis
• Regulatory capital

Notes

1 The sponsor can be the same bank B as assumed in Fig. 1 or another bank that bought the originated loans.

2 This two-step transfer procedure, which requires the creation of a second SPE, was introduced by banks to meet US GAAP conditions, under which the bank does not have to recognize on its balance sheet the assets transferred.

3 The servicer collects payments and monitors the securitized assets, receiving a fee for the service.

4 Numbers in the figure are for illustrative purposes only.

5 Subprime loans are loans made to those who have impaired credit. Generally, these loans have higher interest rates than prime loans and credit ratings of A- or lower.

6 Leveraged loans are loans made to companies or individuals that already have considerable debt.

7 MBSs are ABSs whose underlying financial assets are mortgages.

8 This example was taken, with modifications, from Coval et al. (2008).

9 Accounting standards changed after the financial crisis. Since the main purpose of this work is to determine the contribution of securitization accounting to the financial crisis, when not otherwise specified, we refer to accounting rules in the pre-crisis period.

10 See IAS 39.

11 When the EU applied IAS 39 in 2005 it excluded some provisions. The provisions excluded are not directly relevant to our analysis.

12 We follow Adhikari and Betancourt's (2008) description of the six-step procedure.

13 The biggest US banks (i.e., Bank of America, JPMorgan Chase, Citigroup) increased their incidence of bank charges over revenues from 40 percent in 1995 to 76 percent in 2007 (see Wilmarth, 2009). Consequently, in 2006 US banks reported extremely high executive compensations and revenues (see Coval et al., 2008).

14 Tier 1 capital includes permanent shareholders’ equity and disclosed reserves, while Tier 2 capital includes undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, and hybrid (debt/equity) capital instruments.

15 In this first example we suppose that the fair value of ABS tranches is equal to the carrying amount of securitized loans.

16 Net of any transaction costs.

17 Unless the bank classifies the retained interests security as trading.

18 Nonetheless, according to IAS 39, bank B could not derecognize the transferred assets because it retained the most junior ABS tranche and the corresponding risk.

19 With some notable exceptions.