October 31, 2011 | Research Feature

The Value of an Invisible Guarantee

Better, more accurate disclosure of securitization transactions may help to reduce uncertainty about the value of financial institutions.

Financial institutions have long used securitization transactions to pool debts — mortgages, car loans, or credit card debt — and, through third parties, repackage and sell the pools as bonds or collateralized mortgage obligations, to investors. These third parties, known as SPEs, or special purpose entities, function strictly as investment vehicles for banks, and exist only on paper, with no employees or physical offices. Instead of investors directly buying the debts from the bank, they invest in SPE-issued bonds, effectively isolating the underlying debt payments from loss in the event the bank defaults. This unique structure makes investing through SPEs a less risky practice than investing through banks. However, this structure also has costs from the standpoint of debt investors since they have no legal ability to go after the bank assets if the SPE becomes distressed. While SPEs cannot technically default, when securitized debt pools falter, SPE debt investors face the prospect of not being paid.

Although generally viewed as mutually beneficial for both investors and banks, accounting and finance experts have long debated how banks should disclose securitization transactions. Before 2008, the standard accounting treatment usually categorized securitization transactions as sales of assets, which kept the loans off the bank’s balance sheet. This allowed banks to sidestep disclosing much information about the loans, as would have been required for loans appearing on the balance sheet. However, it became apparent that this accounting approach might not be capturing the whole transaction.

In the last 15 years, says Professor Dan Amiram, researchers have noticed that banks have routinely bailed out failing SPEs in order to protect SPE investors. Moreover, it appeared as if bank equity investors were viewing the transferred loans as if they still belonged to the bank despite the fact that the loans had been legally sold. Since securitization transactions are generally beneficial to the banks, by ensuring banks maintain their reputations in the securitization market, they keep this source of funding available by ensuring payments to the SPE debt investors. Since explicit guarantees negate the benefits of the transaction, banks offer implicit guarantees to SPE debt investors, making unspoken assurances that they won’t let SPEs go under. These guarantees allow a bank to get a better deal on the transferred assets — backed by the bank’s reputation.

In 2008, the understanding that banks offer implicit guarantees prompted a change in the accounting treatment of securitization transactions. The current accounting treatment is to treat the transaction like secured borrowing, rather than being treated as sales of assets, the latter of which would take them off the balance sheet. Under the secured borrowing approach, the loans stay on a bank’s balance sheet as bank assets.

But Amiram, along with Wayne Landsman of the University of North Carolina, Kenneth Peasnell of Lancaster University, and Catherine Shakespeare of the University of Michigan, thought neither of these methods accurately reflected securitization transactions. They suggest that a securitization transaction is neither a sale of assets nor secured borrowing but is instead a unique transaction in which the bank transfers assets and offers an option (the implicit guarantee) to the SPE investors for cash. Ignoring the unique characteristics of the transaction may create uncertainty and ambiguity among bank investors. To back their claim, the authors show that during the financial crisis, bank investors did not view the sold loans as if they belonged to the bank. This finding suggests that at least as perceived by the bank investors, the transactions could not be viewed as secured borrowing during that time. The researchers continued by focusing on impaired retained interest. Retained interest is a small portion of assets sold — usually around 5 percent — that a bank holds on to so that it, instead of SPE investors, takes the first loss when loans go bad. Impairing retained interest indicates that the bank has lost faith in that particular securitization transaction, Amiram explains. “Investors understand that the value of the loans transferred to the SPE has taken a hit. Knowing this, the bank’s investors then try to predict whether the bank will honor its implicit guarantee to SPE investors.”

Under normal conditions, a bank generally accepts the liability of bailing out the SPE when it fails. But during distressed periods — when there is greater uncertainty about the future profitability of the securitization market and bailing out the SPE can lead the bank into financial distress — whether the bank will bail out the SPE is unclear. The researchers combed through the 2007 and 2008 financial statements of the top 100 banks in the United States, looking for banks that announced they were impairing retained interest. “2007 and 2008 were not normal times; we found that when a bank announced that they impaired their retained interest during the crisis, the uncertainty and disagreement among investors about the bank’s value significantly increased,” Amiram says. “Moreover, we found that investors were worried that other investors might have better information about whether the bank would bail out the SPE, which could have detrimental consequences for the bank’s value.”

As a benchmark, the researchers also looked at other financial assets held by banks — those that were not loans sold to SPEs — that remained on banks’ balance sheets. “We see that there is a completely different market reaction when a bank impairs other types of assets, because there is better information about these assets — they’re always on the balance sheet, they belong to the bank, there are no questions about who really owns them. But with securitization transactions, when there is an implicit guarantee and the option to pay investors or not, investors don’t know exactly what their value is and who owns them because they don’t have complete information about them.”

In other words, the way securitization transactions are perceived should change, and these transactions should be accurately reflected in the accounting treatment. “Viewing securitization transactions as either secured borrowing or as sales of assets does not reflect the true economic nature of these transactions,” Amiram says. “A securitization transaction is a distinct type of transaction, and if the accounting disclosure does not give enough information about the implicit options that are attached to the transferred assets, the market can’t evaluate what’s going on.”

The researchers argue that instead of the two traditional but opposing approaches to disclosure, a securitization transaction should instead be viewed as a transfer of assets with two options: an option in which a bank repays SPE investors because the loans the bank sold are bad; and a default option in which the bank can refuse to pay investors. “Giving investors information about the value of these options may significantly reduce the uncertainty around bank values,” Amiram says.

Dan Amiram is assistant professor of accounting at Columbia Business School.

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