Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

Appendix II. The Basel Rules off the Balance Sheet

APPENDIX II The Basel Rules off the Balance Sheet Chapter 1’s account of the process by which mortgage bonds were produced is an oversimplification (of course), in large part because of its omission of the role of off-balance-sheet entities (OBSEs), legal vehicles into which banks could place assets. Again oversimplifying, there are two basic types of such vehicles, for our purposes: Those that were instrumental to the creation of ‘‘structured’’ (tranched, overcollateralized) as well as unstructured asset-backed bonds (pools of assets that were rated but were not tranched or overcollateralized); and those that were the final resting places of these bonds. Often bonds sold against unstructured collateral pools—asset-backed commercial paper, or ABCP—would be used to fund the creation of structured bonds, such as PLMBS. This process was countenanced and, indeed, encouraged by the Basel rules. Why would a bank hold assets off its balance sheet, how would this be done, and why would regulators countenance it? The easiest question to answer is ‘‘how.’’ A bank would establish a special-purpose vehicle (SPV) or special-purpose entity (SPE), whose assets were sometimes accounted for on, but usually off, of a bank’s balance sheet. An SPV/SPE is a legal entity that purchases certain assets—‘‘receivables’’— from the sponsoring bank. As for ‘‘why,’’ Al L. Hartgraves and George J. Benston (2002, 246) explain: Also called special purpose vehicles, SPEs typically are defined as entities created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company. They may take the legal form of a partnership, corporation, trust, or joint venture. 164 Appendix II SPEs began appearing in the portfolio of financing vehicles that investment banks and financial institutions offered their business customers in the late 1970s to early 1980s, primarily to help banks and other companies monetize, through off-balance-sheet securitizations , the substantial amounts of consumer receivables on their balance sheets. A newly created SPE would acquire capital by issuing equity and debt securities, and use the proceeds to purchase receivables from the sponsoring company, which often guaranteed the debt issued by the SPE. Because the receivables have limited and reliably measured risk of nonrepayment, a relatively small amount of equity usually was sufficient to absorb all expected losses, thus making it unlikely that the sponsoring company would have to fulfill its guarantee. In this way the sponsoring company could convert receivables into cash while paying a lower rate of interest than the alternative of debt or factoring, as the debt holder could be repaid from the collection of the receivables by the sponsor. SPEs also allow the sponsors to remove receivables from their balance sheets, and avoid recognizing debt incurred in the securitization. In the case of structured PLMBS, the ‘‘receivables’’ are the payments expected from the mortgagors. Investors bought PLMBS partly on the strength of various types of commitments that the sponsors offered to back up the bonds issued against these receivables. For instance, a bank that retained the equity tranche of a PLMBS thereby offered a credit enhancement to investors in bonds issued from the rated tranches. For unstructured asset-backed bonds, such as asset-backed commercial paper (ABCP), a commercial bank that sponsored the SPE into which it sold its mortgages offered liquidity enhancements to the bond purchasers. Asset-Backed Commercial Paper The ultimate appeal of each type of bond to investors (whether the investors held the bonds on or off their balance sheets) varied considerably. Chapter 1 explains how overcollateralization and tranching, or ‘‘subordination ,’’ made PLMBS, CDOs, and other structured pools of assets appear ultrasafe to investors in the senior (AAA) tranches, even when the collateral in the pool, such as subprime mortgages, seemed unsafe individually. The The Basel Rules off the Balance Sheet 165 appeal of the mezzanine tranches, by contrast, was that investors in these tranches received much higher coupons, in exchange for bearing the brunt of the risk of default. The appeal of ABCP, which paid even lower coupons than did the senior tranches of PLMBS and CDOs, was primarily its safety. As Hartgraves and Bentston put it, the receivables backing ABCP ‘‘have limited and reliably measured risk of nonrepayment.’’ We would be the first to point out that historically reliable risks do not necessarily translate into future probabilities . But as we argue in the Conclusion, this does not necessarily make investors, or regulators, unwise in...