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Abstract
Securitization to attain bankruptcy remoteness separates the risks of the originator bank from the income-producing asset by structuring the asset sale between the Special Purpose Vehicle and the transferor as a “true sale” as opposed to that of financing an asset transfer. Should the transferor subsequently file for bankruptcy, the transferred assets will be exempted from the transferor’s bankruptcy estate, and the investors’ secured assets in the SPV are not at risk of loss. Once commercial banks no longer bear the risk of these bankruptcy-remote securitized loans, creeping deterioration in bank lending standards occurred/are occurring via weaker screening, lower denial rates, and misreporting of credit quality. When this type of structured finance became institutionally pervasive, what may have reduced risk at the micro-level quietly engenders non-linear systemic risk. In remedy to this, the Dodd-Frank Wall Street Reform is at best an incomplete international vision. Regulators must make-up for its inadequacies by increasing capital adequacy requirements which ensure banks operate in a prudential manner. Profit-maximization (shareholders) and capital adequacy (Society) must err on the side of capital adequacy given the public-private hybrid nature of money that is backstopped by the private-public Federal Reserve.
Acknowledgments
This article is dedicated to Professors Kenneth C. Kettering (Columbia Law School) and Didier Sornette (ETH Zurich) whose legal theory and monetary theory insights pervade this article. Given the extensive revisions, this article was also greatly enhanced by the repeatedly incisive comments of the two anonymous reviewers. Any errors, of course, are my own.
Notes
1 An SPV is unlike an operating company in that it has: (1) thin capitalization; and (2) no independent management or employees; and (3) external management of the SVP’s assets; and (4) legally engineered bankruptcy remoteness.
2 Both Standard & Poor and Moody’s Investors Service augmented their typical letter ratings with additional information essentially delineating the conventional rating into a distinct stratification that focused on depicting the likelihood of default as opposed to odds of ample recovery subsequent to any default. This was done by Moody’s through distinct ratings dubbed, “probability of default” and “loss given default,” and in Standard & Poor’s through “recovery ratings.”
3 Mutual funds every quarter must file with the SEC its portfolio holdings report on forms N-CSR, N-CSRS, and N-Q. This applies equally to MMFs, which usually lists their holdings of certificates of deposits, repurchase agreements and commercial paper. For repos, the reports list each repurchase agreement with the notional amount, repo rate, initiation date, repurchase date, counterparty, the type of collateral, and at the report date, the value of the collateral.
4 The collateral portfolio is nearly always comprised of securities of the same type (usually U.S. Treasury bonds of different maturities and vintages, rather than Treasury bonds mixed with corporate bonds or asset-backed securities) (Krishnamurthy, Nagel, and Orlov Citation2014).
5 Subprime MBS prices are more acutely responsive to ratings than ex post performance, implying that financing is overly responsive to credit ratings in relation to didactic content.
6 Bankruptcy Code § 362(a).
7 Bankruptcy Code § 362(d)(1); United Sav. Ass’n v. Timbers of Inwood Forest Assocs., 484 U.S. 365 (1988).
8 Bankruptcy Code § 506(b). Even an adequately over-collateralized secured party can suffer economic loss since the Code does not require any post-petition interest that accrued be paid.
9 The point of such a bailout is not primarily to buy risky assets off the market but to thwart a liquidity-spiral from destabilizing those assets’ market-price that is also double-timing as collateral in the market-based credit system. This price support provided by trading options could very well remain unexercised and so never be accounted for on the Federal Reserve’s balance sheet, but critically, would prevent a collapse of asset-values from current use as collateral (Mehrling 2012).
10 Dodd-Frank Act, Pub. L. No. 111–203, § 941, 124 Stat. 1376, 1890–91 (2010) (creating 5% risk retention provision). Section 941 defines a securitizer as “an issuer of an asset-backed security”; or “a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer” (Mehrling Citation2012). The section also defines an originator as a person who “through the extension of credit or otherwise, creates a financial asset that collateralizes an asset backed security”; and “sells an asset directly or indirectly to a securitizer” (Mehrling Citation2012).
11 An eligible horizontal retained interest (EHRI) involves retaining the most subordinate 5% of the vehicle.
12 Credit Risk-retention Rule, 79 Fed. Reg. at 77,605-08 (stating original purpose of Dodd-Frank Act and identifying new requirements).
13 Frame (Citation2018) provides an exhaustive survey of the existing literature, focusing on securitization of residential mortgages.
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Notes on contributors
Emir J. Phillips
Emir J. Phillips, DBA JD/MBA is an Economics Instructor at the Walton College of Business, University of Arkansas, Fayetteville, USA.