Assessing Financial Reporting Transparency of Securitization Transactions

The rapid growth of the securitization market in the early part of the last decade was one of the key catalysts in the creation of the credit and housing market ‘boom and bust’ cycle, which then precipitated the 2007– 08 sub-prime credit crisis. According to an OECD Journal paper, global securitization issuance across asset classes peaked at around US$4 trillion in 2006 but slumped during the crisis. For example, U.S. non-agency issuance fell from US$2.2 trillion in 2006 to US$129 billion in 2010. One enabler of unchecked and morally hazardous behavior where banks engaged in imprudent and excessive lending was limited transparency regarding key risk exposures arising from structured finance instruments. The poor quality and lack of information also affected investors’ ability to appropriately price and accordingly limit their direct exposures to these instruments. In other words, investors were unable to effectively exercise market discipline.

Securitization typically involves a sponsor/originator transferring a portfolio of financial assets (e.g., mortgages, credit card receivables, student loans, etc.) to a special purpose entity (SPE) in exchange for funding. To obtain funding, the SPE issues securities, and its investors have rights to the expected cash flows arising from the assets held within the SPE. Securitization transactions are normally structured such that the sponsor/originator has ‘skin in the game’ through a retained interest (e.g., via holding an equity/first-loss tranche) and/or other forms of continuing involvement such as recourse or guarantee arrangements, servicing arrangements, and providing certain derivative instruments.

Tightening Reporting Requirements

The financial crisis highlighted a range of shortcomings associated with the recognition, measurement, and disclosures of transferred financial assets, including those involving securitized assets. These shortcomings were evident under both U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). A recurrent deficiency in the run-up to the crisis was the failure by many sponsor/originator firms to consolidate their associated SPEs — notwithstanding that the sponsor/originator entities often had continuing involvement with SPEs. This particular problem was more pronounced under U.S. GAAP relative to IFRS, as it was easier for banks to capitalize on the bright line requirements (e.g., quantitative thresholds) within U.S. GAAP (i.e., FIN 46-R, Consolidation of Variable Interest Entities) to avoid consolidation. Another deficiency, as acknowledged by the Financial Stability Forum (FSF, the predecessor body to the Financial Stability Board), was the poor or non-existent disclosure of risk exposures (e.g., contingent liabilities) arising from both the consolidated and unconsolidated transferred assets.

Subsequently, both the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) have strengthened their guidance on this aspect of financial reporting. The IASB has issued standards (IFRS 10 and IFRS 12) effective from 1 January 2013 and replacing IAS 27. Furthermore, updates to IFRS 7 disclosure requirements for financial assets transfers were effective from 1 July 2011. In the U.S., Statements 166 and 167, replacing Statement 140 and FIN 46-R, were effective from 1 January 2010. While not exactly the same, both IFRS and U.S. GAAP emphasize an evaluation of controlling interest for the consolidation decision. The determination of controlling interest is based on multiple considerations, including whether an entity has power to direct activities and has exposure to risks and rewards in other entities. The controlling interest judgment goes beyond assessing quantitative thresholds, and both IFRS and U.S. GAAP approaches are expected to yield similar consolidation outcomes. Both standards have strengthened the disclosure requirements. In addition, the FSF recommended enhanced disclosures of structured assets and encouraged uptake of these disclosures through national banking supervisory authorities.

Several questions arise. For one, what will be the impact of the new accounting standard requirements on consolidation patterns of securitized transactions (i.e., what is the amount and number of previously unconsolidated SPEs that now will be consolidated)? What will be the impact of recognizing the gains or losses associated with previously de-recognized financial assets and associated liabilities? And finally, will disclosures yield greater transparency on structured assets?

Early indications of the impact of IFRS 10 suggest that its application could result in both recognition and derecognition of transferred assets within the balance sheet. For example, in April 2013, Barclays Bank restated its 2011 and 2012 annual statements, including the impact of the new IFRS 10 consolidation rules. The balance sheet restatement shows that trading portfolio assets worth £1.3 billion were brought on balance sheet, while £1.8 billion of customer loans were derecognized. Concurrently, the profit before tax for year-end 2012 increased by £551 million. Profit increases included the reversal of impairment (i.e., £322 million) and increases in trading income (i.e., £256 million) associated with the previously de-recognized assets.

Key Analytical Considerations

Regardless of the impact of new accounting standards, the baseline analytical considerations should be an evaluation of the following:

• The extent to which asset transfer transactions represent true sales that justify de-recognition (i.e., non-consolidation) versus whether these transactions are de facto borrowing transactions where consolidation would be warranted so that financial statements reflect true leverage.
• The extent and nature of continuing involvement of sponsor/originator entities in the SPEs.
• The respective carrying values, fair values, and risk exposures of:

1. Transferred assets that are consolidated due to continued involvement of sponsor/originator
2. Derecognized transferred assets
3. Retained interest

• The measurement risk associated with the reported values. Valuation error can easily arise with structured finance transactions due to the fiendishly complex nature and possible phases of illiquidity of these instruments. Thus, sensitivity analysis disclosures are necessary for investors.
• The existence of implied guarantees and associated contingent liabilities. Such guarantees can arise due to reputational concerns that would force entities to reacquire transferred assets. For example, in 2007, Citibank voluntarily reacquired US$49 billion of securitized assets and assumed US$87 billion of liabilities. The exposure from the reacquired assets exceeded the potential loss of US$25 billion from its retained interest and was likely done for reputational reasons. One indicator of potential greater losses or additional liabilities due to implied guarantees would be the impairment of the retained interest. Such impairment signals losses of the underlying transferred assets.

The usefulness of financial reporting information related to structured financial instruments depends on the extent to which the above analytical considerations are communicated..

Securitization Market Likely To Recover, Enhanced Disclosure Necessary

Admittedly, investor appetite for the originate-to-distribute business model has been significantly tarnished, as evidenced by a shrinking securitization market. That said, at some point this aversion to this asset class will likely change. As pointed out in the OECD Journal paper, the possibilities for global economic recovery are likely to be linked to the recovery of the securitization market, as it can be a vital form of financing and risk sharing if applied properly. It is therefore imperative that companies enhance their reporting of the risks associated with this form of financing, to minimize the pathological aspects of its application (i.e., misinformed investors due to poor disclosures and unduly risky lending practices).

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