GLOBAL FINANCIAL CRISISThe Influence of Accounting Rules for Securitisation

by Andrew Read1

SECURITISATION

What is securitisation? Accounting for securitisation Contribution to global financial crisis Issues for regulators

2

WHAT IS IT?

A process of changing non-tradable debt into tradable debt by combining the non-tradable debt into a portfolio

and issuing tradable debt financial instruments

secured by the portfolio Frequently used for consumer and small business

debt Home mortgages Credit cards Personal loans Student loans Small business loans

3

REASON 1 – AVAILABILITY OF FUNDS

Increase the amount of funds available for these types of loans be getting funds from debt markets Pension and superannuation funds Insurance companies Corporations with excess cash

4

REASON 2 – LIQUIDITY

Consumer loans like mortgages are for long terms 25 years in Australia 40 years in USA

Investors reluctant to commit their cash for that long

Securitisation financial instruments are tradable which makes them liquid

5

REASON 3 – DIVERSIFICATION

Combining different debt instruments in one portfolio reduces unsystematic risk Apartments, small houses, large houses Different cities (and countries) Non-mortgage debt

6

DIVERSIFICATION THEORY – MARKOWITZ MODEL

jkkj

n

kkj

n

jp rXX

11

X = proportion of security

σ = standard deviation

r = correlation coefficient

j, k = security

p = portfolio 7

DIVERSIFICATION THEORY CONTINUED

As long as rjp < 1 Correlation between existing portfolio and new

security And σj ≤ σp

Risk of new security less than or equal to risk of existing portfolio

Adding additional securities will reduce the risk of the portfolio

8

VANILLA PROCESSOriginator

Promoter

Securitisation entity Financial marketsBorrower

9

VANILLA PROCESS – ARRANGING THE MORTGAGE

Mortgage originator negotiates loan with consumer Aussie Home Loans is an example of an

originator Gets a fee for doing so

Promoter creates securitisation entity Gets a fee for doing so

Securitisation entity provides money to consumer and receives principal and interest payments over the life of the loan Payments may be passed via the originator

10

VANILLA PROCESS – POOLING

Securitisation entity repeats the process of providing mortgages Common to issue 200 – 300 mortgages to create

the portfolio

11

VANILLA PROCESS - SECURITISATION

Securitisation entity issues debt instruments (bonds) to financial markets CMO bonds – collateralised mortgage obligation

bond CDO bonds – collateralised debt obligation bond ABS – asset backed security

12

ADD-ON – GUARANTEE

To improve the credit rating of securitisation debt, the entity can purchase a guarantee Typically provided by a financial institution A major part of Fannie Mae’s business was to sell

these guarantees The originator, the promoter or another entity

may be the guarantor

13

COST OF DEBT BY RATING

S&P Rating Basis Points over LIBOR

AAA 30

AA+ 45

AA 47

AA- 48

A+ 53

A 56

A- 69

BBB+ 135

BBB 150

BBB- 308

BB+ 375

Ashcraft, A. B., & Schuermann, T. (2008). Understanding the Securitization of Subprime Mortgage Credit. SSRN eLibrary. Retrieved April 27, 2009, from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1071189.  

14

ADD-ON – OVER-COLLATERALISATION

To improve the credit rating, the promoter may put more assets into the portfolio than needed

The promoter will receive any surplus when the portfolio is liquidated The originator or another entity may be the

promoter

15

ADD-ON – TRANCHING

A proportion of the bonds issued (called a tranche) may be given a higher priority for repayment High ranking tranches get a better credit rating

(hence, lower interest rate) than low ranking tranches

16

ACCOUNTING FOR SECURITISATION

Typically, securitisation entities are not consolidated by: Originator Promoter Guarantor

Use structures to get around consolidation standard Special purpose entities

17

GAME PLAYING USING SECURITISATION

Non-consolidation of securitisation entities encourages game playing Lowering leverage ratios

18

REGULATION OF FINANCIAL INSTITUTIONS

Financial institutions must maintain sufficient capital under national and international regulations Called capital adequacy

Debt to asset ratio < 92% This is a simplification

Securitisation entities are not regulated

19

THE GAME

Sell assets (mortgage assets typically) to a securitisation entity

Use proceeds to repay debt

20

EXAMPLE – PART 1

Bank Ltd has $1,000m in assets (receivables on mortgages and other loans) and $920m in liabilities Debt to asset ratio 92.0%

Sells $100m in assets to securitisation entity for $99m and uses proceeds to repay debt

Assets now $900m and liabilities $821m Debt to asset ratio now 91.2%

21

EXAMPLE – PART 2

Bank Ltd sells guarantee to securitisation entity for $1m and uses proceeds to repay debt

Assets now $900m, liabilities $820m Debt to asset ratio now 91.1%

Better debt to asset ratio means: Lower marginal cost of debt – maybe Less chance of breaching government

regulations Capital adequacy

22

BUT

Has the risk of Bank Ltd changed as a result of these transactions?

23

CONTRIBUTION TO GFC

First, the impacts: On guarantors On holders of bonds

Then, the contribution

24

GUARANTORS

The increase in default level on mortgages has required the guarantors to pay on the guarantee

Some of the largest guarantors were: AIG Lehmann Bros Fannie Mae

25

HOLDERS OF BONDS

If the bonds were not guaranteed or if the guarantor is insolvent and

If there have been a large number of defaults on the mortgages in the portfolio

Then the holders of bonds will not be getting their principal and/or interest payments

26

TOXIC ASSETS

Bonds which are not paying interest and/or principal are one type of “toxic asset”

The secondary market for these bonds has disappeared so holders cannot sell or liquidate them

27

IMPACT ON REPORTS

Most bonds are required by IAS 39 (and equivalent SFAS and AASB) to be recorded at fair value

With changes in fair value recorded in the income statement

28

IMPACT ON CAPITAL ADEQUACY

If the holder of the bonds is a financial institution

The reductions in fair value of the bond assets can send its debt to asset ratio above 92% In breach of capital adequacy requirements

29

IMPACT ON DEBT COVENANTS

Debt contracts often contain restrictions (covenants) based on leverage ratios

If the permitted leverage is exceeded then Penalty interest rates apply and/or The loan must be repaid immediately

Write-downs of bonds can place a company in breach of its debt covenants

30

CONTRIBUTION – SECURITISATION ACCOUNTING

Ability to use securitisation as an OBF vehicle may have led to excessive securitisation

Inadequate disclosure of exposure to risks from securitisation may have led to incorrect risk assessments by shareholders and creditors

31

CONTRIBUTION – WRITE-DOWN OF CMOS

Write-down of bonds may have put companies in breach of debt covenants and capital adequacy rules Forced companies to repay debts or pay higher

interest when they have insufficient cash Insolvency or government bail-out

32

CONTRIBUTION – INDIRECT

One of the immediate impacts of the GFC was to make companies re-evaluate credit risk also called counter-party risk

Fear and distrust of accounting reports may have caused adverse selection problem led to collapse of inter-bank market which

caused massive contraction in money supply which

caused worst recession in 80 years

33

ISSUES FOR REGULATORS – SECURITISATION

How to report securitisation? Options for regulators:

Require consolidation – but by whom? Originator Promoter Guarantor

Require disclosure in notes Net or gross?

No change

34

ISSUES FOR REGULATORS – REPORTING WRITE-DOWNS

When bonds’ values falls Adjust to fair value and record loss in income

statement Adjust to fair value and record loss in reserves Do nothing until realised

35

ISSUES FOR REGULATORS – MARKET COLLAPSE

The market for bonds has collapsed No-one is buying Cannot observe fair value

How should fair value be reported? At $0 Based on DCF estimating default and risk-

adjusted discount rate (mark to model) At last observed market price

36