Asset Securitization and Public Company Financial Structure
Securitized products may have their origin in the US financial markets of the 1970s, but in Asia it was not until after the Asian financial crisis of the late 1990s that the market for such products really began to take off. Taiwan, closely following the international footsteps, enacted its "Financial Asset Securitization Act" and "Real Estate Securitization Act" in July 2002.
Asset securitization involves very extensive professional knowledge, drawing on such areas as law, accounting, taxation, underwriting, finance, credit rating analysis and asset valuation. This article will take an accounting perspective and attempt to discuss the effect of asset securitization on publicly traded companies.
Sale or mortgage?
The goal of asset securitization is to free up assets so that the underlying value can be accessed and used effectively. An enterprise (the originator) takes certain long-lived assets such as bank mortgages, the accounts receivable of a leasing company or rights to the future revenue from pieces of real estate, and issues them to investors in the form of securities. A stream of future revenue (interest, rent or repayment of principal) is transferred to the investors in exchange, and the seller satisfies its need for funds.
One may question, however, whether raising funds this way is not so much a selling of assets, in which case the funds raised should be recognized as capital gains upon disposal of assets, as it is a mortgaging of assets, in which case the funds should be recognized as a liability. In practice, most such matters are decided on the basis of Statement of Financial Accounting Standards (SFAS) No. 33, "Accounting for Transfers of Financial Assets and Extinguishments of Liabilities", which was issued by Taiwan's official standards-setting body in May, 2003. Most often, the originator of a securitization plays two roles: It is both the owner of the assets and the issuer of the securities. But if the subsequent transfer of those financial assets to a special purpose entity (SPE) constitutes a "true sale", then the financial assets originally on the books should be taken off ("derecognized").
Under the provisions of SFAS 33, when an enterprise loses control over the contract forming the financial assets, it should derecognize those financial assets, and at the time control over the financial assets is transferred, they should be shown to have been sold for an amount up to the consideration received in the transaction (usually cash). In accounting, the criteria for determining that control is lost include: The transferred assets are separated from the transferor; the transferees each have the right to impawn or exchange the transferred assets; the transferor has not signed any agreement giving it the right or obligation to redeem the transferred assets.
Strict conditions for derecognizing assets are intended to prevent companies from deceptively dressing up their financial statements under the name of securitization. Such precautions are warranted because special arrangements may be used to make transactions appear to be sales whereas in reality they should be treated as secured loans. In practice the originator will often retain a certain proportion of the proceeds for credit enhancement purposes, and will agree in a trust deed with a trustee that the transferor may buy back the securities when the balance of circulating securities falls below a certain level and the transferor feels the pool of capital is uneconomical based on cost-benefit considerations. Does such an arrangement contradict the conditions for derecognition? In this writer's opinion, if the proportion of assets that are retained for credit strengthening, or that may be repurchased according to an agreement, is not substantive, then the assets as a whole may still be derecognized.
Changing financial structure
When an enterprise derecognizes financial assets, doing so may bring about changes in the current year's balance sheet conditions, and the effect on financial structure is indeed direct. For example, it will raise the asset turnover ratio and rate of return, and thus improve the operations and profit picture. If a corporation uses the funds raised from an asset securitization to pay off liabilities, the simultaneous reduction of both assets and liabilities will make its capital ratios look better.
As for financial structure, the main advantages of asset securitization include: (a) an increase in the equity capital ratio - which lowers risk since the derecognized assets are risky; (b) lower exposure to bank interest rate risk - because of the long duration of most mortgage loans, many having fixed interest rates, any change in bank interest rates exposes the bank to interest rate risk. Also, the average duration of loans is longer than the average duration of deposits. If the difference between the two is great, it will lead to a serious imbalance in the time structure of assets and liabilities. Asset securitization is a way to reduce these risks.
The development of asset securitization in Taiwan is still in its initial stages, and the system may still have bugs that need to be worked out, but its future development holds much promise, and enterprises will find that asset securitization is a good way to add new life to their financial statements.