Question

What do you mean securitization? Is there any accounting disclosures for securitization in the context of Local accounting standards? What are the motivations for and alternatives to securitization? Also, discuss the fair value concept of transferor’s journal entry for a transfer of financial assets in your own words.

Answer 1

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which generate receivables) and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities(ABS). The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience dramatic credit deterioration and loss.

Disclosures relating to Securitisation

The ‘Notes to Accounts’ of the originating banks should indicate the outstanding amount of securitised assets as per books of the SPVs sponsored by the bank and total amount of exposures retained by the bank as on the date of balance sheet to comply with the Minimum Retention Requirements (MRR). These figures should be based on the information duly certified by the SPV's auditors obtained by the originating bank from the SPV.

MOTIVATIONS FOR SECURITISATION

1 Literature Review
A considerable body of research has been dedicated to understanding the motivations for securitisation. Accounting motivations are linked to the income, balance sheet, and regulatory capital effects of securitisation.

1.1 Economic Motivations
The majority of studies seeking to understand whether economic reasons are the
driving force behind securitizations focus primarily on firms in the financial industry. By showing evidence that the levels of capital maintained by securitizing banks corresponds to the market’s perception of risk, Calomiris and Mason (2004) conclude that economic reasons such as risk allocation and increased market monitoring motivate credit card banks to engage in securitisation.

1.2 Earnings Management Motivations
From an accounting angle, the originator of securitization can achieve several
accounting benefits by structuring securitization transactions as sales rather than secured borrowings.By showing that securitization transactions have stronger earnings and regulatory capital effects than loan transfers, Karaoglu (2005) concludes that biased reporting in the form of discretion over the valuation of retained interest is another source of earnings management in securitisation.

2 Hypothesis Development
Collectively, existing financial industry studies document evidence that supports
both economic motivation and accounting motivation for securitisation. Empirical evidence of an association between liquidity and securitization decisions provides support for the notion that securitization can be economically beneficial in that it mitigates the underinvestment problem.

2.1 Financing Choices and the Underinvestment Problem
In one of the most cited papers on corporate finance, Myers and Majluf (1983) present a model analysing firms’ financing choices in the presence of information asymmetry between firms (hereafter, managers) and outside investors. Securitisation can mitigate this underinvestment problem, because it avoids the information asymmetry problem in equity financing and reduces debt financing costs.

2.2 Liquidity Demand and Securitization
In securitization, securitized assets are segregated from a firm’s general operating
risk. Liquidity demand is inversely related to the deviation of cash holdings from the optimal levels estimated in the model.

2.3 Earnings Management Incentive and Securitization
Prior studies have shown that accounting motives, particularly earnings management, explain why firms engage in securitisation. Based on the evidence showing the existence of earnings management in securitization alone, it is unclear whether the incentive to manage earnings motivates firms to engage in securitisation.

2.4 Economic Consequences of Earnings Management in Securitization
In prior studies, earnings management in securitisation has been viewed as an undesirable practice. The presence of earnings management in securitization is associated with the level of overinvestment consequent to securitisation.

Alternatives to securitisation

The growth of the US securitization market has been primarily due to mortgage-backed securities, whereas Europeans have historically tended to trade in covered bonds. Covered bonds are very much part of the European bond framework. As of mid-2007, the covered bond market ranked as the sixth-largest market in the world and the largest asset class in Europe. One of the strongest cases for a covered bond market is in reaction to the 2007 global financial crisis. Relative to the US securitization market, the covered bond market is regarded as having had a “good crisis” (OECD 2011) because the market continued to be very resilient against the backdrop of the 2007 global financial crisis. When bank funding markets seized up European lenders were still able to issue covered bonds.

Fair Value Concept

Fair value is used in two distinct ways in accounting for transfers of financial assets for which the transferor has surrendered control over the assets as (partial) sales. First, the transferor recognises the ‘net proceeds’ from the transfer at fair value. Second, the transferor recognises retained beneficial interests in the transferred assets at the carrying value of the transferred financial assets times the percentage of the fair value of those assets attributable to the retained beneficial interests. Together, these uses of fair values imply that the extent to which a transfer is accounted or as a partial rather than complete sale rises with the percentage of the fair value of the transferred financial assets attributable to the retained beneficial interests.