The Market s View on Accounting Classifications for Asset Securitizations. Dissertation

Transcription

1 The Market s View on Accounting Classifications for Asset Securitizations Dissertation Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of The Ohio State University By Minkwan Ahn, M.Acc. Graduate Program in Accounting & MIS The Ohio State University 2014 Dissertation committee: Anne Beatty, Advisor Darren Roulstone Andrew Van Buskirk Haiwen Zhang

2 Copyright by Minkwan Ahn 2014

3 Abstract Prior research examines how investors view asset securitizations, and shows that investors treat securitizations as borrowings even when GAAP treats them as sales. Upon the adoption of two new accounting standards relating to asset securitizations, some offbalance-sheet securitized assets were consolidated back onto firms balance sheets. This study examines whether the new accounting standards result in financial reporting that is more aligned with investors views of asset securitizations. To address this question, this study investigates how investors viewed previously off-balance-sheet securitized assets before the two new standards became effective. In doing so, it separately examines assets that firms consolidated under the new standards and those that firms left unconsolidated. I find that investors differentiated between these two types of securitizations, treating the consolidated assets as borrowings and the unconsolidated assets as sales. I conclude that the new accounting standards are more consistent with equity investors views of asset securitizations. ii

4 Acknowledgments For its guidance and support on this study, I thank my dissertation committee: Anne Beatty (Chair), Darren Roulstone, Andrew Van Buskirk, and Haiwen Zhang. I also thank Samuel Bonsall, Michael Iselin, Bret Johnson, Allison Nicoletti, and Austin Sudbury as well as workshop participants at The Ohio State University, University of Hong Kong, Hong Kong University of Science and Technology, Chinese University of Hong Kong, City University of Hong Kong, Hong Kong Polytechnic University, Seoul National University, and Korea Advanced Institute of Science and Technology for helpful comments and suggestions. I gratefully acknowledge financial support from the Fisher College of Business. iii

5 Vita April 2008 B.S. Accounting, Brigham Young University April 2008 M.A. Accounting, Brigham Young University 2009 to present.graduate Research Assistant, Accounting & MIS, The Ohio State University Fields of Study Major Field: Accounting & MIS iv

6 Table of Contents Abstract...ii Acknowledgments..iii Vita.....iv List of Tables.vii Chapter 1. Introduction...1 Chapter 2. Background on Asset Securitizations Typical Structure of Asset Securitizations Accounting for Asset Securitizations SFAS 140 and FIN 46(R) SFAS 166 and SFAS Chapter 3. Related Literature Review...20 Chapter 4. Hypotheses Development...25 Chapter 5. Research Design...28 v

7 5.1 Tests of H1 - H Tests of H Chapter 6. Sample and Descriptive Statistics...40 Chapter 7. Results Tests of H1 - H Tests of H Chapter 8. Robustness Tests...48 Chapter 9. Conclusion...51 References...54 Appendix A: Accounting Standards for Asset Securitizations...58 Appendix B: 10-K Filings Examples - Impact of SFAS 166 and SFAS Appendix C: Variable Definitions...60 Appendix D: Sample Selection Procedures...62 Appendix E: Tables...63 vi

8 List of Tables Table 1. Descriptive Statistics Table 2. Distribution of Estimated SPE Assets (EST_Securitized) Table 3. Relation between Equity Risk (σ R ) and QSPE and VIE Assets...67 Table 4. Relation between Equity Risk (σ R ) and Estimated SPE Assets (EST_Securitized)...68 Table 5. Relation between Estimated SPE Assets (EST_Securitized) and Consolidated Securitized Assets (CONS_Securitized) Table 6. Relation between Equity Risk (σ R ) and QSPE and VIE Assets beyond the Type of Assets...70 Table 7. Relation between Equity Risk (σ R ) and QSPE and VIE Assets Using Other Deflators...72 Table 8. Relation between Equity Risk (σ R ) and QSPE and VIE Assets beyond Influential Observations...74 vii

9 Chapter 1. Introduction Asset securitizations are a large source of financing for firms, especially for banks. Banks that securitize assets are typically among the largest banks. Securitizing banks make up 83% of total assets for all banks. Barth et al. (2012) report that the size of the median securitizing bank is over $40 billion in assets. Among securitizing banks, Barth et al. (2012) report that securitized assets constitute on average 20% of the banks total assets. Securitization transactions are accounted for as either sales or secured borrowings and many of the transactions are treated as sales under GAAP. However, various groups including financial analysts and investors argued that these transactions should be considered borrowings because firms may retain significant risk in securitized assets transferred to special purpose entities (SPEs) by providing implicit (i.e., non-contractual) recourse on the assets. To provide insight into the ongoing controversy over the accounting for asset securitizations, prior research examines how investors view asset securitizations, and indicates that investors assume that on average firms will provide implicit recourse on securitized assets (Niu and Richardson 2006; Landsman et al. 2008; Chen et al. 2008; Barth et al. 2012). Concerns about implicit recourse became apparent during the recent 1

10 financial crisis. 1 These concerns led the Financial Accounting Standards Board (FASB) to issue two new accounting standards, SFAS 166 and SFAS 167, resulting in firms bringing some of their off-balance-sheet securitized assets back onto their balance sheets. This study examines whether the two new accounting standards result in financial reporting that is more aligned with investors views of asset securitizations. To address this question, this study investigates how investors viewed previously off-balance-sheet securitized assets before the new standards became effective. In doing so, it separately examines assets that firms consolidated under the new standards and those that firms left unconsolidated. Then, extending prior research, this study also examines whether, for assets consolidated under the new standards, investors distinguished between securitizations going through two different accounting structures prior to the adoption of the new standards. 2 By addressing whether the new accounting standards are more consistent with investors views of asset securitizations, this study provides evidence on the relative effectiveness of the new accounting standards to the old accounting standards at identifying implicit recourse. 3 In a typical securitization transaction, a firm transfers pools of financial assets such as mortgages and credit card receivables into an SPE that finances the acquisition of these assets by issuing debt securities. Because the securitizing firm knows more about the credit risk of the transferred assets, the firm usually provides some form of recourse 1 Two well-known examples of securitizing firms providing implicit recourse are that in 2007 HSBC Holdings and Citigroup bailed out their SPEs, bringing onto their balance sheets $45 billion and $49 billion of the SPE assets that had been accounted for as sales (The Economic Times 2007; Sidel 2007). 2 Throughout the paper, I use the term consolidated assets ( unconsolidated assets ) to refer to securitized assets that had been treated as sales under old accounting standards, SFAS 140 and FIN 46(R), but were (were not) consolidated under new accounting standards, SFAS 166 and SFAS I use the term more effective to describe the accounting that is more likely to identify securitizations to which the securitizing firm will likely provide implicit recourse. 2

11 to the SPE investors to protect them against potential future losses from these assets. A common feature of securitizations is that the securitizing firm retains first-loss interests in the transferred assets by holding the most junior asset-backed securities issued by the SPE. Because explicit guarantees to the SPE violate accounting rules allowing sale accounting, the securitizing firm may instead provide implicit recourse to its troubled securitizations to make up some portion of the losses not covered by the retained interest in securitized assets. 4 5 The possible presence of implicit recourse makes it difficult for investors to assess the extent of the risk retained. This is because implicit recourse was neither disclosed nor recognized in the financial statements under the old accounting standards and the securitizing firm may or may not honor its implicit commitments at its discretion. Therefore, to assess the extent of the risk retained by the securitizing firm, investors should estimate the likelihood and extent of the firm providing implicit recourse. Prior to 2010, firms were able to keep securitized assets off their balance sheets using either qualifying special purpose entity (QSPE) or variable interest entity (VIE) accounting. QSPE and VIE accounting were allowed under SFAS 140 and FIN 46(R), respectively. QSPE accounting focused on ensuring that the securitizing firm had relinquished control over the assets, while VIE accounting emphasized the extent that the firm had retained risks and rewards from the assets. In the wake of the recent financial 4 In 2002, the Federal Financial Institutions Examination Council (FFIEC) released a list of four major actions that can signal implicit recourse: (1) selling assets to the SPE for less than their fair value, (2) purchasing assets from the SPE at a price greater than their fair value, (3) exchanging better quality assets (i.e., performing assets) for worse quality assets (i.e., non-performing assets), and (4) providing recourse or other credit enhancement beyond contractual requirements. 5 Following Barth et al. (2012), I use the term retained interest to refer to the portion of securitized assets that the securitizing firm retains and recognizes as the interest. I also use the term non-retained interest to refer to the portion of securitized assets that the firm treats as sold to SPEs. The sum of retained and nonretained interest is the total securitized assets. 3

12 crisis, regulators and the FASB expressed serious concerns about whether QSPE and VIE accounting properly captured implicit recourse associated with asset securitizations (PWG 2008; Emmons 2010; FASB 2009a; FASB 2009b). To improve the transparency of securitization transactions, the FASB issued two new standards, SFAS 166 and SFAS 167, in Among other things, SFAS 166 eliminates the QSPE exemption from applying VIE accounting, and SFAS 167 replaces the quantitative analysis required under FIN 46(R) with a qualitative analysis. 6 As such, all QSPEs and VIEs in existence upon the adoption of the new standards had to be evaluated for the consolidation of VIEs in accordance to SFAS 167. As a result, some of the QSPE and VIE assets that had been treated as sales under the prior QSPE/VIE accounting were consolidated back onto firms balance sheets as required by the new VIE accounting. Regulators and the FASB believe that the new VIE accounting is more effective at identifying implicit recourse than the prior QSPE/VIE accounting (FR 2010; FASB 2009b). However, given the discretion allowed under the new VIE accounting, it is not necessarily more effective at identifying implicit recourse. If the new VIE accounting is more effective at identifying implicit recourse than the prior QSPE/VIE accounting, then investors should have treated as secured borrowings those previously off-balance-sheet securitized assets that were ex-post consolidated as required by the new VIE accounting. If this is true, then the elimination of QSPE accounting and the replacement of the old VIE accounting with the new VIE accounting will result in financial reporting that is more aligned with investors views of asset securitizations. Thus, an investigation of how 6 I use the term old VIE accounting to refer to the quantitative analysis required under FIN 46(R) and use the term new VIE accounting to refer to the qualitative analysis required under SFAS

13 investors assessed implicit risk associated with the consolidated assets prior to the adoption of SFAS 166 and SFAS 167 provides insight into the benefits of the analysis required under these two new standards. Prior research on asset securitizations examines whether investors view securitizations as sales or secured borrowings. These studies predict that if investors anticipate that the securitizing firm will provide implicit recourse to the firm s underperforming securitizations, then their assessments of the firm s credit risk should reflect risk associated with securitized assets transferred to SPEs. Consistent with this prediction, the prior studies find that the securitizing firm s credit risk is positively associated with securitized assets transferred to SPEs. This positive relation indicates that investors assume that, on average, firms will provide implicit recourse on securitized assets, which suggests that investors treat securitizations as secured borrowings on average even when GAAP treats them as sales. Upon the adoption of the two new standards, some securitized assets were consolidated back onto firms balance sheets, but others continued to be accounted for as sales. This raises the question whether, as implied by prior research, investors view all securitizations as secured borrowings or they treat some securitizations as secured borrowings, but others as sales. This question is simple, but very important because firms debt-to-assets ratio would dramatically increase if they were to record all of their securitizations as borrowings. With the passage of SFAS 166 and SFAS 167, we can distinguish between securitizations that may have the economic substance of borrowings versus sales. 5

14 The findings from prior studies are limited in that they do not distinguish between securitizations going through two different accounting structures, QSPEs and VIEs, in examining investors views on asset securitizations. By meeting conditions required under the prior QSPE/VIE accounting, securitizing firms demonstrated that they had transferred control of the assets to SPEs, but they may have retained significant risk in the assets by providing implicit recourse on the assets. QSPE accounting took into account only the securitizing firm s explicit obligations, but significantly limited the firm s involvement with QSPEs to ensure that the firm had relinquished control of the assets. On the other hand, VIE accounting considered both the firm s explicit and implicit obligations, but the securitizing firm had more discretion under VIE accounting in making assumptions to estimate its exposure to VIEs (Harp 2005; Niu and Richardson 2006; Moody s 2010; PCAOB 2011). Given such differences between the two accounting structures, investors may or may not have distinguished between securitizations going through QSPEs and VIEs with respect to implicit recourse in assessing the extent of the risk retained. Extending prior research, this study examines whether investors distinguished between QSPEs and VIEs prior to the adoption of SFAS 166 and SFAS 167. To identify QSPE and VIE assets that the securitizing firm would likely provide implicit recourse, I use QSPE and VIE assets that were ex-post consolidated as required by the new standards. The QSPE assets were consolidated due to both the elimination of QSPE exemption from applying VIE accounting and the replacement of quantitative analysis required under the old VIE accounting with a qualitative analysis. On the other hand, the VIE assets were consolidated only due to the replacement of the quantitative analysis with a qualitative 6

15 analysis. As such, if QSPE accounting was significantly less effective at identifying implicit recourse than the old VIE accounting, then investors should have assumed that the securitizing firm would be more likely to provide implicit recourse for the consolidated QSPE assets versus the consolidated VIE assets and thus assessed higher implicit risk for the consolidated QSPE assets versus the consolidated VIE assets. Thus, examining whether investors assessed differential implicit risk for the consolidated QSPE assets versus the consolidated VIE assets prior to the adoption of the new standards provides evidence on the relative effectiveness of QSPE accounting to the old VIE accounting at identifying implicit recourse. Consistent with prior research, my empirical analysis focuses on the relation between the securitizing firm s equity risk and the level of securitized assets accounted for as sales. Prior research predicts that if equity-holders assess that the securitizing firm bears significant risk in implicit recourse beyond the firm s contractual obligations, then total securitized assets are positively associated with equity risk beyond the retained interest. While prior research focuses on the pre-crisis periods, the sample period of this study continues into One caveat of this study is that investors may have changed their views on securitizations during the recent financial crisis. 8 To distinguish between securitizations that may have the economic substance of borrowings and sales, I hand-collect from banks 10-K filings for the fiscal year 2009 QSPE and VIE assets that were either consolidated or unconsolidated upon the adoption 7 To test the equity-holders views on asset securitizations before and after the new standards became effective in 2010, the sample period of this study spans 2009 to Amiram et al. (2011) argue that because of the systematic drop in the value of firms assets during the crisis, securitizing firms may not have had the means or willingness to honor their implicit recourse. They document that the positive association between firms market value of equity and securitized assets sold to SPEs became insignificant in

16 of SFAS 166 and SFAS 167. These assets had been treated as sales during fiscal year 2009 under the prior QSPE/VIE accounting. Then, as required by the two new standards, some of the assets were added back onto firms balance sheets for the first quarter of 2010 and others continued to be accounted for as sales. I hand-collect the amounts of these assets from firms 10-K filings for the fiscal year 2009 that were issued during the first quarter of I first test whether investors assessed differential risk in implicit recourse for the consolidated assets versus the unconsolidated assets before the two new standards became effective. Then, I test whether for the consolidated assets investors distinguished between QSPEs and VIEs with respect to implicit recourse prior to the adoption of the new standards. For these tests, I regress equity risk on the level of the assets that was not observable at the time when the equity risk was measured. As such, following prior research, I make an assumption that investors could accurately assess the level of risk associated with securitized assets. Out of 49 banks that had positive securitized assets in at least one quarter between 2008 and 2009, 14 and 7 banks consolidated their QSPE and VIE assets back onto their balance sheets, respectively. The findings from this study reveal that equity risk is significantly positively associated with the consolidated assets beyond the unconsolidated assets. This positive relation indicates that investors anticipated that firms would provide implicit recourse for the consolidated assets before the new standards became effective. These findings suggest that investors treated the consolidated assets as borrowings prior to the adoption of the new standards. Regarding the unconsolidated assets, equity risk is not significantly 8

17 associated with the assets, which provides no evidence that investors treated the unconsolidated assets as borrowings prior to the adoption of the new standards. Disaggregating the consolidated assets into consolidated QSPE and VIE assets, I find that equity risk is significantly positively associated with both of the assets. These findings suggest that investors treated the consolidated QSPE and VIE assets as borrowings prior to the adoption of the new standards. More importantly, the t-test shows that the coefficients on these assets are not significantly different from each other. These findings indicate that for the consolidated assets, there is no evidence that investors distinguished between QSPEs and VIEs with respect to implicit recourse prior to the adoption of the new standards. I also test the investors assessments of risk associated with securitized assets between 2010 and 2012, that is, after the new standards became effective. I find that equity risk is significantly positively associated with the retained interest in securitized assets, but is not significantly associated with the non-retained interest in the assets. These findings provide no evidence that investors continue to treat securitizations as borrowings after the new standards became effective. Overall, the findings from this study imply that i) investors treated consolidated assets as secured borrowings prior to the adoption of SFAS 166 and SFAS 167, ii) for consolidated assets, there is no evidence that investors distinguished between QSPEs and VIEs with respect to implicit recourse prior to the adoption of the new standards, and iii) after these assets were consolidated, there is no evidence that investors continue to treat securitizations as borrowings. These findings overall suggest that the new accounting standards are more consistent with equity investors views of asset securitizations. If 9

18 investors are correct in assessing the extent of the risk retained, then these findings imply that the new VIE accounting is more effective at identifying implicit recourse than the prior QSPE/VIE accounting. The findings above suggest that investors distinguished between securitizations that should have been treated under the new standards as borrowings versus sales even before the new standards required firms to do so. A natural follow-up question is how investors could have distinguished between these different types of securitizations given the lack of disclosure about securitizations. One possible information channel that investors could use is the regulatory Y-9C report. A bank s primary Federal supervisor has the authority to require a bank to add its securitized assets back into its risk-weighted assets for regulatory capital purposes if the agency assesses that the bank has retained significant implicit risk beyond its contractual obligations (FR 2010). Investors may be able to estimate the banking agencies implicit recourse adjustments from the regulatory report and use these estimated adjustments to identify those SPEs to which the securitizing firm will likely provide implicit support beyond the firm s contractual obligations and to estimate the extent of such support. To test whether investors can estimate and use the banking agencies implicit recourse adjustments in assessing the extent of the risk retained, I estimate the amounts of securitized assets added back to banks risk-weighted assets from Y-9C reports arising from the adjustments of formerly off-balance-sheet securitized assets. The findings reveal that equity risk is significantly positively associated with the estimated implicit recourse adjustments. These findings suggest that investors are able to estimate and use the banking agencies implicit recourse adjustments in assessing the extent of the implicit 10

19 risk retained. Put differently, investors views about implicit recourse are consistent with the banking agencies implicit recourse adjustments. This study contributes to the literature relating the risk relevance of asset securitizations along several dimensions. First, I provide evidence that SFAS 166 and SFAS 167 result in financial reporting that is more aligned with investors views of asset securitizations. Assuming that investors are correct in assessing the extent of the risk retained, these findings imply that the new accounting standards better reflect the economics of securitization transactions, which is consistent with the FASB s main objective for adopting the standards (FASB 2009a; FASB 2009b). However, readers should be cautious in interpreting the findings because this implication is predicated on the assumption that, on average, investors can accurately assess the level of risk in securitized assets. As suggested in Cheng et al. (2011), some investors may have difficulty in understanding securitization disclosures and as a result, may not be accurate in their assessments. To the extent that this is true, the findings should not be interpreted as suggesting the relative effectiveness of the new accounting standards to the old accounting standards at identifying implicit recourse. The findings should be interpreted as suggesting only that investors views about implicit recourse are more consistent with the new accounting standards than the old accounting standards. The findings from this study imply that investors were able to distinguish between securitizations that were ex-post consolidated and unconsolidated even before the new standards required firms to make the distinction. If on average investors could draw the distinction without such new disclosure, then the natural question is who, if any, will benefit from the new accounting standards. The new disclosure may be useful for 11

20 auditors. The Public Company Accounting Oversight Board (PCAOB) conducted inspections of audit procedures by registered public accounting firms and released a report on its observations related to audit risk areas affected by the recent financial crisis (PCAOB 2010). According to the report, inspectors observed that firms sometimes failed to re-evaluate the accounting for securitizations even when the implicit recourse on securitized assets became explicit. Firms may have failed to incorporate the risk associated with implicit recourse because either they ignore implicit risk or the old accounting standards did not push them strongly enough to incorporate the risk. If the latter is true, then the new accounting standards may be helpful in making auditors take into account the risk associated with implicit recourse. Next, no current study has offered a mechanism by which investors could estimate the amount of risk retained in off-balance-sheet items. By providing evidence on the information used by investors, this study sheds light on the mechanism and thereby, presents findings that are potentially useful to standard setters. The remainder of the paper proceeds as follows. Section 2 provides background information about asset securitizations. Section 3 reviews related research and Section 4 discusses my hypotheses. Section 5 describes the research methodology. Section 6 describes the sample selection process and descriptive statistics. Section 7 presents the empirical analyses and Section 8 discusses robustness tests. Section 9 concludes. 12

21 Chapter 2. Background on Asset Securitizations 2.1 Typical Structure of Asset Securitizations In a typical securitization, a firm transfers pools of financial assets such as mortgages and credit card receivables into an SPE. In return, the SPE conveys the cash it receives from outside investors back to the securitizing firm. Because the securitizing firm knows more about the credit risk of the transferred assets, the firm usually provides some form of recourse to the SPE investors to protect them against potential future losses from these assets. In the context of securitization transactions, recourse usually refers to guaranties promised to investors in asset-backed securities allowing the transfer of some losses back to the originating firm if the performance of the underlying pools of securitized assets deteriorates (Cheng et al. 2011). Therefore, the extent to which the securitizing firm retains risk associated with securitizations varies depending on how much recourse, if any, the firm will provide to its underperforming securitizations. Recourse can take either an explicit (i.e., contractual) or implicit (i.e., noncontractual) form. For example, as an explicit form of recourse, the securitizing firm typically retains the most subordinated asset-backed securities that bear the first loss from the pool of securitized assets. Because explicit guarantees to the SPE violate accounting rules allowing sale accounting, the securitizing firm may instead offer an implicit promise to support its troubled securitizations to make up some portion of the losses not covered by the retained interest. Even though the securitizing firm is not legally obligated 13

22 to honor its implicit recourse, the firm may choose to do so to maintain its reputation and future access to securitization markets (Gorton and Souleles 2005). Loss of reputation can expose firms to decreased liquidity, increased interest rate risk, and potential burdensome regulatory supervision (Cheng et al. 2011). The possible presence of implicit recourse offered by the securitizing firm makes it difficult for investors to assess the extent of the risk retained. This is because implicit recourse was neither disclosed nor recognized in the financial statements under SFAS 140. Thus, it is difficult for investors to identify such implicit commitments. Further, the securitizing firm may or may not honor its implicit commitments at its discretion. 9 Therefore, to assess the extent of the risk retained, investors should estimate the likelihood and extent of the securitizing firm providing implicit recourse. 2.2 Accounting for Asset Securitizations Prior to 2010, firms were able to keep securitized assets off their balance sheets using either QSPE or VIE accounting. QSPE and VIE accounting were allowed under SFAS 140 and FIN 46(R), respectively. After the beginning of 2010, all securitizations should be evaluated for off-balance-sheet treatment in accordance to SFAS 166 and SFAS 167. SFAS 166, among other things, eliminates the QSPE exemption from applying VIE accounting and SFAS 167 replaces the quantitative analysis required under VIE accounting with a qualitative analysis SFAS 140 and FIN 46(R) 9 In April 30, 2009, Advanta Corp. announced at its earnings call that it would support its credit card securitizations to prevent early amortization. However, In May 11, 2009, Advanta Corp. announced that it will shut down all of the accounts in the securitization trusts without supporting them. 14

23 Prior to 2010, to obtain off-balance-sheet treatment for assets transferred to an SPE, the securitizing firm was required to demonstrate that the transfer of the assets met the conditions required under SFAS 140 to be treated as a sale, and that the firm did not have a controlling financial interest in the SPE in accordance to FIN 46(R). However, QSPE accounting allowed under SFAS 140 provided a means to demonstrate that the securitizing firm had relinquished control of the transferred assets. Therefore, if an SPE was considered a QSPE, then the SPE was exempt from consolidation requirements required under FIN 46(R). As such, each securitization involving QSPEs needed to meet only the conditions required under SFAS 140. Under SFAS 140, securitization transactions could be accounted for as sales rather than as secured borrowings if the transfer of all or a portion of a financial asset met all of the three conditions: (1) the transferred assets must be isolated from the transferor and its creditors even in bankruptcy, (2) the SPE (or each holder of its beneficial interests if the SPE is a QSPE) must have the right to pledge or exchange the assets (or beneficial interests) it receives, (3) the securitizing firm does not maintain effective control over the transferred assets through certain forms of continuing involvement (e.g., the obligation to repurchase the transferred assets). If a securitization transaction was considered a sale, then the securitizing firm removed the securitized assets from its balance sheet, and recognized the proceeds received from the SPE and the firm s retained interest in the assets. The securitizing firm s implicit recourse was not considered To determine the gain or loss on sale of the assets, the firm allocated the carrying amount of the securitized assets to the retained and non-retained interest based on their relative fair values. 15

24 To be considered a QSPE, an SPE should have been significantly limited in certain aspects. For example, the assets the SPE could hold and the activities the SPE could perform should have been significantly limited and entirely pre-specified in the legal documents. The SPE could also dispose of its assets only in automatic response to pre-specified events (e.g., a default by the obligor). These conditions required under QSPE accounting ensured that none of the parties involved in securitization transactions actively managed the transferred assets, and therefore, meeting the conditions demonstrated that the securitizing firm had relinquished control of the assets. Thus, for those securitizations that qualified for off-balance-sheet treatment under QSPE accounting, the securitizing firm may not have had the incentive and/or opportunity to provide support beyond the firm s contractual obligations and thus, may have borne minimal risk associated with implicit recourse. However, the conditions required under QSPE accounting took into account only the firm s contractual obligations and the firm s non-contractual obligations such as implicit recourse were not considered. As such, QSPE accounting may not have been effective at identifying securitizations to which the securitizing firm would likely provide implicit recourse. The conditions for the consolidation of VIEs under FIN 46(R) emphasized the quantitative-based risks and rewards calculation for determining which of the entities had a controlling financial interest in a VIE. An SPE was considered a VIE if the SPE was insufficiently capitalized or was not controlled through voting (or similar rights). If an SPE was considered a VIE, then a variable interest holder had to consolidate assets and liabilities held in the VIE if it was a primary beneficiary of the VIE. A firm was considered a primary beneficiary if it absorbed a majority of the VIE's expected losses, 16

25 received a majority of the VIE s expected residual returns, or both. Therefore, the primary beneficiary was exposed to the greatest risks and/or rewards associated with assets and liabilities held in the VIE, which justified the consolidation of the VIE by the securitizing firm considered the primary beneficiary. In contrast to QSPE accounting, VIE accounting explicitly required the securitizing firm to consider its implicit recourse as well as explicit recourse in estimating its exposure to potential losses from assets transferred to VIEs (FASB 2003; FSP 2005). As such, VIE accounting may have been more effective at identifying implicit recourse than QSPE accounting. However, the securitizing firm had more discretion under VIE accounting in making assumptions to estimate its exposure to VIEs (FASB 2009b). Thus, it is possible that the securitizing firm might not have incorporated any of its implicit recourse. Therefore, VIE accounting may not have been more effective at identifying implicit recourse SFAS 166 and SFAS 167 As observed during the recent financial crisis, some securitizing banks actually provided implicit recourse to their off-balance-sheet securitizations. Regulators and the FASB expressed serious concerns about QSPE accounting that had been misused by some firms. The FASB was also concerned that the quantitative analysis required under VIE accounting did not always capture situations in which securitizing firms provided implicit recourse to their VIEs (FASB 2009b). 11 In response, the FASB issued two exposure drafts to amend SFAS 140 and FIN 46(R) in September These two drafts 11 For example, some sponsors sold their interests to third parties that absorbed the majority of the VIEs expected losses. However, these parties typically had very limited power to direct the activities (FASB 2009b). 17

26 propose to eliminate the QSPE exemption from applying VIE accounting and to make changes to the analysis required under VIE accounting. Along with the drafts, in December 2008, the FASB also issued FSP FAS and FIN 46(R)-8, which require firms to provide additional disclosures about their continuing involvement with SPEs. The two exposure drafts led to two new standards issued in June 2009, SFAS 166 and SFAS 167, which became effective at the first annual reporting period that begins after November 15, For firms with a calendar year end, the new standards became effective from January 1, SFAS 166, among other things, removes the QSPE exemption from applying VIE accounting and requires retained interest to be measured at fair value. Changes to SFAS 140 other than the removal of the QSPE exemption must be applied to transfers occurring on or after the effective date, and all QSPEs in existence upon the adoption of the statement had to be evaluated for the consolidation of VIEs in accordance to SFAS 167. This new statement replaces the quantitative tests with qualitative tests to determine whether a securitizing firm is a primary beneficiary of the VIE. As such, all VIEs in existence upon the adoption of SFAS 167 also had to be evaluated for the consolidation of VIEs in accordance to this new statement. As a result of the adoption of SFAS 166 and SFAS 167, some QSPE and VIE assets were consolidated back onto firms balance sheets. These assets had been treated as sales during the fiscal year 2009 under the prior QSPE/VIE accounting. Then, as required by the two new standards, the assets were added back onto firms balance sheets for the first quarter of I hand-collect the amounts of these consolidated assets from 12 Please see Appendix A for the timeline of accounting standards for asset securitizations. 18

27 firms 10-K filings for the fiscal year 2009 that were issued during the first quarter of Under SFAS 167, a variable interest holder is considered a primary beneficiary if it has the power to direct the activities of a VIE that most significantly impact the entity s economic performance and has the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. Under the new VIE accounting, the FASB expects only one party to be the primary beneficiary. However, if power is shared among multiple unrelated parties, then no party is the primary beneficiary. 13 Such a qualitative approach may more readily identify implicit arrangements because it analyzes the characteristics of variable interests and VIEs, including their purpose and design, which could help identify which of the entity has the incentive and opportunity to establish implicit arrangements (FASB 2009b). The FASB expects that the qualitative approach is more effective at identifying implicit recourse than the quantitative approach (FASB 2009b). 14 However, the qualitative approach may require firms to make even more subjective judgments and assumptions in determining the primary beneficiary. As such, the qualitative approach may not be more effective at identifying implicit recourse. 13 Power is shared if two or more unrelated parties have the power to direct the activities and if decisions about those activities require the consent of each of the parties (paragraph 14D, FASB 2009b). 14 The banking agencies also note that such qualitative analysis converges in many respects with their assessments of banks credit risk exposure to VIEs (FR 2010). 19

28 Chapter 3. Related Literature Review Accounting for asset securitizations has been controversial for decades. Even though many securitization transactions were treated as sales under GAAP, various groups argued that these transactions should be considered borrowings. This is because firms may retain significant risk in the transferred assets by providing implicit recourse on securitized assets. To provide insight into the ongoing controversy surrounding the financial reporting for assets securitizations, prior research examines investors views about implicit recourse. One caveat for addressing this question is that implicit recourse was neither recognized nor disclosed under GAAP and if any, there are only a handful of events when firms announced that they had committed to provide implicit recourse to their underperforming securitizations. Because the risk associated with the transferred assets should capture the risk associated with implicit recourse, prior research examines whether investors assess significant risk in the transferred assets to test investors views about implicit recourse. To draw a policy implication, prior research has relied on the assumption that investors can accurately estimate the risk associated with implicit recourse. Following this line of research, this study also assumes that investors can accurately assess the level of risk in securitizations to test investors views about implicit recourse. To examine investors views about implicit recourse, prior research focuses on the investors assessments of the relation between the securitizing firm s risk and securitized 20

29 assets. These studies predict that if investors anticipate that the securitizing firm will (will not) provide implicit recourse beyond the firm s contractual obligations to its troubled securitizations, then the measure of the firm s risk should (not) be positively associated with the portion of assets transferred to SPEs. Niu and Richardson (2006) show that offbalance-sheet debt related to asset securitizations has the same risk relevance as does recognized debt for explaining market measures of equity risk (i.e., CAPM beta). Landsman et al. (2008) show that SPE assets and liabilities are valued similarly to sponsor-originator banks (S-Os) assets and liabilities. These findings indicate that equityholders assume that on average firms will provide implicit recourse on securitized assets, suggesting that investors view securitizations as secured borrowings even when GAAP treats them as sales. Assuming that investors can accurately assess the risk in securitizations, these studies argue that their results raise questions about whether the sales accounting treatment for asset securitizations appropriately reflects the risk associated with implicit recourse. Chen et al. (2008) investigate whether the equity-holders assessments of risk associated with securitizations vary with the type of assets securitized. They show that equity return volatility is positively associated with both retained and non-retained interest in securitized residential mortgages and securitized consumer loans, but is positively associated only with the retained interest in securitized commercial loans. These findings suggest that equity-holders perceive that implicit recourse is a more important issue for residential mortgages and consumer loans than for commercial loans. Cheng et al. (2011) investigate the sources of equity risk associated with securitizations. They argue that market participants are likely to find it difficult to assess 21

30 the true extent of risk transfer because of the complexity of and the lack of disclosure about securitization transactions. They predict that the difficulty in estimating the extent of risk transfer is likely to lead to information asymmetry among market participants if some market participants have better information and/or better information-processing abilities. Consistent with their predictions, they find that bid-ask spreads and analyst forecast dispersion increase with the amount of securitized assets, and that securitizing banks have higher bid-ask spreads and forecast dispersion as compared to nonsecuritizing banks. These findings imply that some investors have a greater difficulty in understanding securitization disclosures. This implication suggests that better disclosure about implicit recourse should be incorporated to level the playing field. To test investors views about implicit recourse, following prior research, this study makes an assumption that investors can accurately assess the risk in securitizations. The extent that this assumption is valid is not trivial because different conclusions may be drawn. Niu and Richardson (2006) and Landsman et al. (2008) argue that investors do not rely on the sales accounting treatment because the accounting is not appropriate. On the other hand, Cheng et al. (2011) suggest that investors may not rely on the sales accounting treatment because they have difficulty in estimating the extent of risk transfer. Beatty and Liao (2013) suggest that further research in this area may help reconcile the potential inconsistency. The objective of this study is not to test the validity of this assumption. Following prior research, this study assumes the market efficiency to test investors views about implicit recourse and then to make an implication on the relative effectiveness of the new VIE accounting to the prior QSPE/VIE accounting at identifying implicit recourse. 22

31 Barth et al. (2012) investigate whether two credit market participants, bondholders and Standard & Poor s (S&P s), differ in their assessments of credit risk associated with securitized assets. They find that bond spreads are positively associated with both retained and non-retained interest in securitized assets regardless of the type of assets securitized, whereas S&P s credit ratings are positively associated only with the retained interest in securitized residential mortgages. They claim that if the bond market s assessment of the securitizing firm s off-balance-sheet exposure is unbiased and efficient, then their findings raise questions about the appropriateness of reporting the non-retained interest as sold to SPEs as well as the diligence of credit-rating agencies in assessing credit risk associated with securitizations. 15 Overall, prior research on asset securitizations indicates that investors assume that on average securitizing firms will provide implicit recourse to their underperforming securitizations, suggesting that investors treat securitizations as secured borrowings on average. Upon the adoption of SFAS 166 and SFAS 167, some securitized assets were consolidated back onto firms balance sheets. This raises the question whether, as implied by prior research, investors treat all securitizations as borrowings or they treat some securitizations as borrowings, but others as sales. The findings from prior studies are also limited in that they do not distinguish between securitizations going through two different 15 Another stream of research investigates motivations for asset securitizations. Two of the motivations that have been examined in prior studies are to meet the bank s regulatory capital requirements and to manage earnings. Empirical findings for the regulatory arbitrage motivation are mixed (Minton et al. 2004; Karaoglu 2005). Regarding the earnings management motivation, Dechow and Shakespeare (2009) find that securitization transactions cluster in the last few days of the third month of the quarter, suggesting that managers use securitizations to window-dress the financial statements. Dechow et al. (2010) find that firms report larger gains when pre-securitization earnings are lower and when pre-securitization earnings are below the last year s level. 23

32 accounting structures, QSPEs and VIEs, in examining investors views on asset securitizations. Upon the adoption of SFAS 166 and SFAS 167, some QSPE and VIE assets were consolidated back onto firms balance sheets because firms were deemed to have control over the assets under the two new standards. As such, for those consolidated assets, firms may have the incentive and/or opportunity to provide implicit recourse. However, having control over the assets does not guarantee that firms will provide implicit recourse. Firms may not have the incentive to provide implicit recourse because they assess that the benefit of waiving the recourse is greater than the cost of losing reputation as a player in the securitization market. Thus, whether the new standards capture the risk associated implicit recourse that the prior standards missed is an empirical question. Because implicit recourse is rarely observable, I address the question by examining how investors assessed implicit risk associated with the consolidated assets versus the unconsolidated assets before the new standards became effective. This study also extends prior research by examining whether for the consolidated assets investors assessed differential risk in implicit recourse for assets securitized through QSPEs versus VIEs prior to the adoption of the new standards. 24

33 Chapter 4. Hypotheses Development To test whether investors view all securitizations as borrowings, I use securitized assets that were (were not) consolidated as required by SFAS 166 and SFAS 167 to identify securitizations that the securitizing firm will (will not) likely provide implicit recourse. These two new standards eliminate the QSPE exemption from applying VIE accounting and replace the quantitative analysis required under VIE accounting with a qualitative analysis. As such, if the qualitative analysis is more effective at identifying implicit recourse than QSPE accounting and the quantitative analysis, then investors should have treated, prior to the adoption of the new standards, as secured borrowings those securitized assets that were ex-post consolidated under the qualitative analysis, but others as sales. If this is true, then investors should have assessed significantly higher risk for the consolidated assets versus the unconsolidated assets. Thus, my first hypothesis is as follows. H1: The magnitude of the association between the securitizing firm s equity risk and securitized assets that were consolidated as required by SFAS 166 and SFAS 167 is significantly greater than that of the association between the firm s equity risk and securitized assets that were unconsolidated. To test whether investors distinguished between QSPEs and VIEs with respect to implicit recourse, I use QSPE and VIE assets that were consolidated as required by the two new standards to identify QSPE and VIE assets that the securitizing firm would 25