GLOBAL FINANCIAL CRISIS
The Influence of Accounting Rules for Securitisation
by Andrew Read 1

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
n n
 p
   X j X k  j  k r jk
j 1 k 1
X = proportion of security
σ = standard deviation
r = correlation coefficient
j, k = security
7
p = portfolio

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 PROCESS Promoter
Originator
Borrower Securitisation entity Financial markets
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 Ashcraft, A. B., & Schuermann, T. (2008).
Understanding the Securitization of Subprime
Mortgage Credit. SSRN eLibrary. Retrieved
AA 47 April 27, 2009, from
http://papers.ssrn.com/sol3/papers.cfm?abstra
AA- 48 ct_id=1071189.
A+ 53
A 56
A- 69
BBB+ 135
BBB 150
BBB- 308 14
BB+ 375

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