PrefBlog

The Bank for International Settlements has released its Report on Special Purpose Entitites. Section I is the Executive Summary & Overview:

Section II provides a summary of market developments that contributed to the growth of the securitisation markets that relied heavily on the use of SPEs. Also described is the confluence of factors that played a part in the market crisis that began in mid-2007.

Section III focuses on the motivations of sponsoring firms and investors for employing SPEs. For originators and sponsors, these may include risk management, funding, accounting, or regulatory capital considerations.

Section IV describes the potential for informational asymmetries and problematic incentives to hamper the use of SPEs, examines potential issues and deficiencies in risk management, and explores ways in which risk transfer can potentially be over- or underestimated by both originators and investors.

Section V presents a series of policy issues and recommendations for consideration.

Appendix 1 is a primer on common types of SPE structures and programs, such as RMBS, CMBS, CDOs, ABCP conduits, structured investment vehicles (SIVs), repackaging vehicles, and transformer structures.

Appendix 2 continues with a more technical discussion of common features of SPEs. Legal forms, methods of achieving asset transfer, and accounting and regulatory capital considerations are discussed. Additionally, the roles of key parties to SPEs (eg the sponsor, originator, and servicer) are described, as well as issues related to the control and management of these entities.

Appendix 3 explores how the risk and return of assets in SPEs can be allocated among various parties and counterparties. Different forms of exposure can result from holding certain tranches and residual interests or from providing liquidity and credit guarantees. This section also includes a discussion of triggers, where the cash flows are redirected should a particular event occur.

Appendix 4 provides global data on the use of SPEs by financial institutions according to vehicle type and geography.

Appendix 5 provides the list of members of the Joint Forum Working Group on Risk Assessment and Capital.

The International Monetary Fund has released the (prelimary version of) the Global Financial Stability Report, October 2009, with three chapters:

• The Road to Recovery
• Restarting Securitization Markets: Policy Proposals and Pitfalls
• Market Interventions during the Financial Crisis: How Effective and How to Disengage?

I was happy to see the following in the Executive Summary:

But hard work lies ahead in devising capital penalties, insurance premiums, supervisory and resolution regimes, and competition policies to ensure that no institution is believed to be “too big to fail.” Early guidance at defining criteria for identifying systemically important institutions and markets—such as that being formulated by the International Monetary Fund, Financial Stability Board, and Bank for International Settlements for the G-20—should assist in this quest. Once identified, some form of surcharge or disincentive for marginal contributions to systemic risk will need to be formulated and applied.

A surcharge is infinitely preferable to flat prohibitions and Treasury’s special regime. The report repeatedly warns about “cliff effects” in the securitization market; such cliff effects are a sign of incompetent analysis; prohibitions and special regimes bring about cliff effects by their nature.

They produce an amazing chart decomposing credit spreads that I have trouble taking seriously:

There are no references cited for this decomposition. While I have great respect for IMF research and am sure they didn’t just pluck the numbers out of the air, it’s quite hard enough to decompose spreads into credit risk & liquidity (see, for example, The Value of Liquidity), without adding other factors.

As if on purpose to reinforce my skepticism regarding connections between premises and conclusions, they publish an amazing regression analysis in the section titled “Will bank earnings be robust enough to absorb writedowns and rebuild capital cushions?”:

… with the comment:

To protect bottom line earnings, banks appear to have priced risky lending more expensively—as shown by the upward sloping trend line for European banks in Figure 1.10.

I think they’re trying too hard. Presented by the G-20 with a golden opportunity to expand their bureaucracy – after ten years of looking irrelevance in the face – I suspect that management has sent the word out to come up with the BEST conclusions and the BEST analysis and the BEST policy recommendations right away (for “best”, read “best looking”). Anybody who’s ever read a sell-side economic commentary will be very familiar with this paradigm.

The term-shortening of bank financing was of interest:

We won’t be out of the woods until the term structure of bank liabilities returns to normal.

The second chapter provides a very good overview of securitization.

The Boston Fed has released a Public Policy Discussion Paper by Daniel Cooper titled Did Easy Credit Lead to Economic Peril? Home Equity Borrowing and Household Behavior in the Early 2000s, which dispels at least part of the notion that Americans went insane earlier this decade and spent their home equity loans on beer and prostitutes:

Using data from the Panel Study of Income Dynamics, this paper examines how households’ home equity extraction during 2001‐to‐2003 and 2003‐to‐2005 affected their spending and saving behavior. The results show that a one‐dollar increase in equity extraction led to ninetyfive or ninety‐eight cents higher consumption expenditures. Nearly all of this spending increase was reversed in the subsequent period. A fair amount of these expenditures went toward home improvements and repairs. In addition, households used home equity to help finance their purchases of used cars. Equity extraction also led to some household balance sheet reshuffling. In particular, households who extracted equity were somewhat more likely than other households to pay down their higher‐cost credit card debt and to invest in other real estate and businesses. Overall, the results in this paper are consistent with households’ extracting equity during the first half of this decade to fund one‐time durable good consumption needs.

The author concludes, in part:

Overall, the results suggest that households’ reasons for borrowing against their homes have changed little over time. Households who have lower levels of financial wealth are more likely to extract equity as are households who experience strong local or regional house-price growth. In addition, the consumption analysis suggests that households borrowed against their homes in the early 2000s, to finance one-time consumption shocks. A one-dollar increase in equity extraction led to a roughly ninety-five cent increase in consumption between 2001 and 2003, which did not persist over time. In particular, consumption fell by roughly the same amount in the period ( 2003-to-2005) following the period when households extracted equity.

Additional analysis suggests that households extract equity for one-time, durable goods purchases. Roughly a quarter of each dollar of equity extraction goes toward home repairs and improvements, consistent with anecdotal evidence. Households also extract equity, for used car purchases. There is limited evidence, however, that households’ (non-durable) food purchases increase when they borrow against their homes. The findings also show that households have a roughly 10 percentage point higher predicted probability of paying down their non-collateralized debt when they extract equity than when they do not. Homeowners are also slightly more likely to invest in other real estate or personal businesses when they borrow against their houses. As a result, equity extraction has household balance sheet effects in addition to the effect of households’ borrowing to fund their one-time consumption needs.

The analysis in this paper does not cover the final years of the recent house-price boom, since the PSID data are available only through 2005.

So, while in hindsight it is obvious that American households became over-leveraged during the early part of the housing boom, it is something of a relief to learn that the money was spent on durable goods rather than immediate consumption.

Update, 2009-10-1: The Bank of Canada has released a related study by Ian Christensen, Paul Corrigan, Caterina Mendicino and Shin-Ichi Nishiyama titled Consumption, Housing Collateral, and the Canadian Business Cycle:

Using Bayesian methods, we estimate a small open economy model in which consumers face limits to credit determined by the value of their housing stock. The purpose of this paper is to quantify the role of collateralized household debt in the Canadian business cycle. Our findings show that the presence of borrowing constraints improves the performance of the model in terms of overall goodness of fit. In particular, the presence of housing collateral generates a positive correlation between consumption and house prices. Finally we find that housing collateral induced spillovers account for a large share of consumption growth during the housing market boom-bust cycle of the late 1980s.