The multi-trillion dollar asset securitization market continues to have unresolved issues in the aftermath of the financial crisis, including how the assets are accounted for, and the credit risk assessments done by bond markets and credit-rating agencies, according to a new study.

The research, in the current issue of The Accounting Review, published by the American Accounting Association, probes evaluations of the credit-worthiness of large bank holding companies and finds a marked difference between the way risk was assessed by the bond market on the one hand and a major credit-rating agency, Standard & Poor’s, on the other.

In its assessment of risk, the bond market took into account all asset-based securities issued by the banks in the three categories sampled by the study—those backed by residential mortgages, by consumer loans, and by commercial loans. In contrast, assessments by Standard & Poor’s reflected only the small portion of issued securities that the banks retained in their own accounts, and did so only in the case of residential mortgages but not the other two types.

In the words of the study, the difference "provides insight into allegations that credit-rating agencies were not diligent in assessing the effects of securitizations." Further, the fact "that we only find a significant relation between credit ratings and asset securitizations for one type of asset supports critics' allegations that rating agencies largely ignore securitized assets when developing banks' credit ratings."

Beyond noting that prior research suggests that credit ratings reflect not just considerations of risk but "the incentives of the credit-rating agencies," the study has little to say on allegations that conflicts of interest drove agencies to overrate subprime mortgage-backed securities, conflicts stemming from the fact that companies being evaluated pay for the rating (generally after having been actively solicited for the business). But, whatever the extent of the conflict of interest, the problems of the securitization market go well  beyond that, according to Mary E. Barth of Stanford University, who carried out the new study with Gaizka Ormazabal of IESE Business School in Spain and Daniel J. Taylor of the Wharton School of the University of Pennsylvania.

"It's not surprising that we encountered two markedly different ways of assessing risk given the continuing disagreement among accountants as to whether asset securitizations most fundamentally are sales or collateralized borrowings," said Barth.

In a typical securitization, a firm legally transfers assets—whether residential mortgages or credit-card debt or some other some other kind of receivables—to a special purpose entity, a legal shell set up for the dual purpose of holding the assets and attracting investment. Cash from investors goes from the SPE to the firm that created it, and almost invariably the originating firm retains a portion of the assets for itself, generally the highest-risk portion, as an encouragement to investors. SPEs can be advantageous to investors as a protection against bankruptcy of the originating firm and as a means of diversifying risk among investors, who can have pay-offs tailored to their needs and their degree of risk aversion.

But how asset securitizations should be treated for accounting purposes remains a matter of contention. "Actually, securitization is neither a sale nor a borrowing but something in between," said Barth. In 2005 the Financial Accounting Standards Board and the International Accounting Standards Board launched a project in which Barth participated to work out a single approach to the matter, but after four years no resolution emerged.

"Until the accounting is resolved, ambiguity will invite all manner of complex financial contrivances, which no amount of regulation is likely to counter very effectively,” she said. “After all, how well can you regulate something when its basic nature eludes definition?"

Also unresolved, she added, is the status of credit-rating agencies.

"A Nobel laureate in economics has called the agencies key culprits in causing the world financial crisis, but there is no consensus on what the status of these companies should be. On one side one hears calls to change who pays for ratings or to impose a methodology for ratings; on the other side, it is argued that the payment structure for doing ratings is no different from what it is for auditing and that telling an agency how to do ratings makes about as much sense as telling a doctor how to do surgery.

"In the end, there are two principal ways to think about these agencies,” said Barth. “One is they are as important as banks and insurance companies and have to be as closely subject to regulation as those institutions are. The other is that agencies deserve to have the same freedom of speech as a broker who advises you to buy some particular stock, but let the buyer beware. Either alternative could make sense, but right now we seem to have neither."

The study's findings derive from a probe of risk assessments from 2001 through 2006 of bank holding companies with more than$150 million in consolidated assets. Standard and Poors ratings came in 21 gradations from a high of AAA to a low of C. Risk assessment by the bond market was determined from the difference between the annualized yield of bonds issued by banks and returns on one-month Treasury bills, with greater spreads indicative of greater risk. The study focuses on banks because they are the largest group of asset securitizers, and data on their securitizations are available from the Federal Reserve.

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