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When securitized assets are not off balance sheet

David Harper CFA FRM

David Harper CFA FRM
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David,

In the credit risk module on pg 11 (of 106), you discuss that assets may be securitized and kept on balance sheet if the SPV is set up as a corporation. My question is: Isn't the purpose of securitizing to get assets off balance sheet? When is it beneficial to securitize loans and then keep them on balance sheet? Also, how does that impact overall asset quality at the institution? Thanks, Davidson

Davidson,

Yes, a primary goal of securitization is to sell assets off the balance sheet (i.e., to avoid their consolidation). But it's not the only motive. I think Culp is helpful here when he says "securitization has both a financing [funding] and a risk transfer impact on the original firm." So, while balance sheet avoidance may be an accounting and/or economic motive, a firm also securitizes to raise cash ("monetize credit-sensitive assets") and *transfer risk.* Many of the SYNTHETIC STRUCTURES are so-called exactly because they do not remove the assets from the originator's balance sheet but they still transfer risk away from the originator and toward the investors. There is learning outcome about the difference between a cash CDO and synthetic CDO, where the difference is, really: in a cash CDO, the originator divests the assets (and so of course does not consolidate). But in a synthetic CDO, the originator does not sell the assets; rather, the SPE sells credit protection to the originator. So, a "typical" synthetic CDO does not meet the balance sheet motive but does transfer credit risk to investors. That was a long way of saying "it can be beneficial to securitize and keep them on balance sheet if the motive is credit risk transfer."

Okay, but you are correct in this sense: the trust SPE was invented to qualify assets into off balance sheet status, after the corporate SPE lost that magic due to FIN 46R. Both FAS 140, and later FIN46 (Anti-Enron) to close more loopholes, exist specifically to clarify the rules for avoiding consolidation. That is, they were responses to perceived abuses in the achievement of dubious off balance sheet status. The four criteria in FAS 140 amount to: you must achieve a 'true sale' to avoid consolidation; i.e., sufficient distance between originator and SPE, enough to avoid consolidation. In short, trust SPE, FAS140, and FIN46R are about the pursuit of (trust SPE), or the hurdles required to get (FAS 1410, FIN46R), off balance sheet treatment.

On the overall asset quality, I am unsure how to define asset quality in this context, but for most examples i can think of, the sale (securitization) of an asset tends to provide more asset transparency than just a secured claim. Even for a synthetic securitization, where the securitization achieves risk transfer, that would seem to improve asset quality (maybe even if it lowers ROE due to the CDS premium payments?). But in regard to a regulatory (Basel) perspective, clearly CDOs have been done expressly to lower regulatory capital required. A bank can lower its capital requirement by either a cash or synthetic CDO, so from that perspective, the synthetic CDO (i.e., that does not remove assets from the balance sheet but *does* transfer credit risk) seems to achieve asset 'quality' improvement, for a fee...

To summarize solely for FRM exam purposes:
* Securitization is to sell (credit-sensitive) assets off the balance sheet. Assest sold to either a corporate SPV. Or, for the express purpose of achieving bankruptcy remote status, sold to a trust (i.e., one trust, which deposits the assets in another trust).
* Motivations for securitization include, but are not limited to: get assets off the balance sheet (e.g., smaller equity improves ROE); raise cash; transfer risk
* A SYNTHETIC SECURITIZATION typically does not remove assets from the balance sheet, but transfers credit risk
* FAS 140: if the assets are bankruptcy remote, NOT controlled by originator, and ARE within LIMITED PRE-DEFINED CONTROL of SPE, then yes, it's a true sale and does not need consolidation
 
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