Recent Financial Crisis and the Structured Finance: Accounting Perspective for Future

Part of the Contributions to Management Science book series (MANAGEMENT SC.)


Structured finance techniques, especially synthetic structuring, were applied intensively to ensure sustainable growth of credit mechanism via developing high rated hybrid instruments before recent global shock. The system created a loop that caused systematic risk maximization derived from undesirable default correlation between collaterals. Therefore structured products were seen as the reason for financial crisis and their popularity has begun to fall. On the other side, discussions have started to take place within accounting dimension in recent years. The fundamental point of this perspective was constructed on the efficiency of accounting techniques to provide signals on future hitches and to make market participants properly informed about the values of collaterals. In this study, the tradeoff for applying fair value versus historical cost accounting is discussed in the frame of the connection between recent global shock and structured finance.


Cash Flow Financial Crisis Credit Default Swap Default Probability Future Cash Flow 
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1 Introduction: Overview of Structuring

Structured finance is a system that contains tools and highly complex financial transactions created by financial engineering activities. Structured systems are developed to find solutions in order to meet unique financial needs of companies or investors that could not be fulfilled by traditional financial products. In this sense, structuring is the way of creating hybrid financial securities by developing a system that makes credit risk transfer possible via securitization and using of derivatives for optimum financing or investing.

Securitization is the fundamental technique to develop structured products. A pool of selected assets are packaged and pass-through securities are formed which create liquidity for originator (owner of the assets) and return for investors based on cash flow from assets. In traditional view, this system contains two main building stones called ‘off-balance sheet structuring’ and ‘collateralized obligation’. According to the concept of ‘off-balance sheet structuring’, assets are transferred to standalone ad-hoc vehicle with a finite life called ‘special purpose vehicle or entity-SPV’ by true sale. Thus issuing of asset based securities via SPV makes obligations (liabilities) collateralized by means of retaining selected assets and prior rights on their cash flows as guarantee for possible defaults.

In the simplest term, the fundamental off-balance sheet securitization creates ‘bankruptcy remoteness’ for originator via traditional credit risk transfer (true sale) and provides an opportunity to minimize capital adequacy for banks. In this sense, the aims to apply securitization for banks could be summarized in three directions: Liquidity (financing), equity management and risk management. One forward step in order to increase efficiency of these aims is to integrate credit enhancement techniques into off-balance sheet securitization.

Sorting of collateralized obligations according to priorities of investors' rights composes the mainframe of credit enhancement. This is a technique, called ‘subordination’ to redesign the economic structure of balance sheet by prioritizing the rights of investors on future cash flows generated by assets. Determined cash flow order, titled as ‘cash waterfall’ in the literature, specify default risk of each ‘tranche’ and the more rank in priority means increase in credit score by means of decrease in cumulative default risk of tranche statistically. Collateralized obligations with top priority for rights on future cash flows form senior tranche which has credit quality in highest degree. The others, mezzanine and junior tranches follow senior ones with lower credit quality in terms of cumulative default probability. Residual is the equity trance as workhorse for assets with highest default risk (see Fig. 1). Mind you that residual is the undermost in the cash flow order.
Fig. 1

Credit enhancement by subordination

Cash flow collateralized debt obligations (Cash CDOs) are securities issued based on tranches that formed via subordination in the frame of off-balance sheet securitization. It is important to note that, while asset backed securities are based on complete set of assets pool, cash CDOs are based on identified tranches. This critical differentiation plays an important role on rating. In traditional securitization, in other words securitization without subordination, the default probability of whole asset pool is evaluated. However in securitization with credit enhancement, the default probability of each tranche is taking into account that means the rating of cash CDOs becomes more complex relative to asset backed securities (the traditional rating such as bonds) in terms of identification of diversification.

Making risk transfer via credit derivatives means synthetic structuring. This kind of risk transfer provides some advantages such as increase in speed of transactions, decrease in costs, increase in kinds of assets subject to packaging, and eliminate the need for collateralizing for senior tranche. Synthetic collateralized debt obligations (Synthetic CDOs) derived via credit derivatives based risk transfer varies according to way of credit protection; funded or unfunded. In fully funded mechanism existence of credit protection is provided via ‘credit-linked notes’ by forming portfolio consisting of securities with high credit quality as collateral for possible exposure to a specified credit event on reference tranche or asset. In unfunded synthetic structuring credit production is provided only by using ‘credit default swaps’ means no need for prepayment and so lack of additional collateral pool. Generally ‘basket credit default swaps’ are preferred for unfunded structures due to their convenience on subordination. The structure becomes partially funded when both ‘credit linked notes’ and ‘credit default swaps’ are used. Figure 2 shows the classification of products in the frame of their position to cash markets or credit derivatives.
Fig. 2

Overview of credit risk transfer instruments. Source: Jobst, A.A. (2007) ‘A Primer on Structured Finance’ Journal of Derivatives and Hedge Funds, 13 (3), p. 5

2 Triggers of Financial Shock

Blundell-Wignall and Atkinson (2009) defined the reasons of global financial shock in the frame of by global macro liquidity policies and by a very poor framework for incentives of financial sector agents, conditioned by bad regulations, tax systems and governance standards. They identified financial crisis as follows: “The liquidity policies were like a dam overfilled with flooding water. Global liquidity distortions, including interest rates at 1 % in the United States and 0 % in Japan, China’s fixed exchange rate and recycling of its international reserves, and the Sovereign Wealth Funds (SWF) investments, all helped to fill the dam to overflowing. That is how the asset bubbles and excess leverage got under way.”

Expansionary monetary policy was applied in US to activate the wheels of economy again following dotcom crash and 9/11 attack realized in 2000 and 2001 respectively. Interest rates became a record low of 1 % in June 2003, after remained at that level for a year showed upside fluctuation and reached 5.25 % in June 2006. Simultaneously, increased in money supply caused a sharp and continuous increase in consumer borrowings (see Fig. 3). This situation brought up need for banks on providing liquidity and in the beginning banks used overnight repos in financing that made their value double. Later on, sustainable lending could be provided by using structured finance techniques more. Augmentation of subprime mortgages played critical role on generation of this frame, where the face value of mortgages outstanding reached $2.75 trillion in 2007, of which $1.25 trillion were subprime mortgages, $1 million Alt A debt and $500 billion jumbo ARMs (Zandi 2008, p 44).
Fig. 3

Outlook of US economic indicators (00-08). Source: Federal Reserve System

Decrease in target rates and increase in credits create a loop which produced sufficient profit for financial market players, that means ‘giving more credits and making more money’ without consider diversification in the frame of minimizing default risk. Growing of the housing bubble reached the pick in 2004 with an average price increase nearly 120 % for a typical US house, and the asset values taken into account as collateral played a fictive role for credit protection. Based on high weight of subprime loans in total outstanding amount, the system gave error after sharp declined in housing prices by means of finding adequate assets in value or source to cover the loss of structured products’ investors. The fundamental reason of the error is systematic risk maximization derived from undesirable default correlation between assets.

3 The Rationale of Default Correlation and Systematic Risk

Improvement on credit quality of tranche is closely related with default correlation. Allen et al. (2012) state that crisis that started in 2007 have highlighted the importance of another type of systemic risk related to usage of credit default swaps based financial products. In other words, structured finance practices realized by all financial organizations in the market simultaneously caused indiscernible systematic risk formation. Because, in such a case, diversification aims do not work in the meaning of cumulative default risk minimization. This frame shows the reality of 2007 financial crisis. In this sense, the fundamental reason of the shock could be denoted as increased in default correlation between assets.

Sensitivity of tranches to systematic risk is more than of traditional bonds. Because, traditional bonds are related with only one reference entity while tranches contain a large of variety assets. Therefore, default correlation could not be managed properly in structured finance transactions especially for synthetic ones. In other words, whereas total risk can be minimized by diversification theoretically, during pre-term of global shock default correlations positively increase in practice because of mass and similar structuring applications. This increase caused a systematic risk for packaged assets.

Default correlation between reference assets directly affects integrated default probability. In that the relations between reference assets are randomness if there is no default correlation; means integrated default probability equals to multiplying of reference assets’ default probabilities in simple terms. This desirable situation could provide significant decrease in integrated default probability. Since reference assets (entities) have to be different in all aspects to ensure such a case, it is not realistic. In this sense, the main aim occurs within the scope of selecting assets with negative or poor default correlations. However, existence of mass structuring transactions especially associated with subprime ones applied by in a large number of financial institutions made diversification impracticable during pre-crisis term.

Another point as a reason of systematic risk formation is the increase in asymmetric information. Especially, synthetic structuring abolished the financial statements’ transparencies of financial institutions in terms of risk assessment and valuation of collaterals. In other words during pre-crisis term there were ‘visible’ and ‘invisible’ situations. According to visible picture, the values of collaterals were adequate. On the other side, the real values of collaterals as invisible ones were not same as the values that could be seen in financial statements. In other words, accounting techniques on valuation could not be sufficient for market to obtain signal about the reality of financial market. Thus, increased asymmetry made market uninformed on increased default correlation.

4 Accounting Perspective: M2M or Historical Cost?

The Global Shock showed the weaknesses of structured finance accounting. The insufficiency in the disclosures of structured products and the valuation methods used are defended as the factors increasing the severity of financial crisis. The explanations in financial statements related with the structured finance products have to be sufficient. So, financial statement users can understand the necessary issues without having a problem and decisions taken will be much more accurate. The factor, related with the valuation of structured finance products, affects the severity of the financial crisis is the valuation of these with fair value. Before the crisis, the standard setters support the fair value accounting. As a result of this, financial crisis formed an important debate related with fair value accounting.

In many sources the expression of mark to market (M2M) accounting is used instead of fair value accounting. The definition of fair value in IFRS 13 is as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. Fair value accounting bases on the current values of the future cash flows of assets and liabilities and reports these (Meder et al. 2011). Basically, fair value is a market-based measurement not entity-specific value.

As mentioned in IFRS 13, there are three levels in defining the fair value. These are:
  • Level 1—inputs are quoted prices in active markets for identical assets or liabilities that the entity can access at the measurement date.

  • Level 2—inputs are inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

  • Level 3—inputs are unobservable inputs for the asset or liability.

As the fair value relies on the efficient market hypothesis, in reporting the price in the market is grounded on. For this reason, fair value accounting presents a valuation measure that can be applied in active markets.

There are lots of studies related with the relation between fair value accounting and financial crisis (Allen and Carletti 2008; Badertscher et al. 2011; Barth and Landsman 2010; Heaton et al. 2010; Laux and Leuz 2009a, b; Plantin et al. 2008). Some of these studies support that fair value accounting has an effect on the financial crisis, some relies on that fair value accounting does not have an effect or has a little effect on the financial crisis. Actually, the expression that fair value accounting caused the financial crisis is not so accurate. Instead of this, supporting that fair value accounting increases the severity of financial crisis will be a right judgement.

During the financial crisis, there were sharp decreases in the prices of fixed assets and financial assets. As the companies having these assets applied fair value in valuation, they lost a great amount of money and as a result capital losses happened. In crisis period, since companies sold their assets in fire sales in other words at prices below the fundamental values and as they used fair values as a valuation measure, there was a decrease in the asset valuation in the market. So this situation caused capital losses, companies lost money and even failures occurred. Therefore because of the knock-on effect in other companies applying fair value accounting, the market became much worse. As fair value accounting takes market prices in consideration, a decrease in similar prices affected other companies’ financial statements.

Standard setters are also blamed for the severity of financial crisis. Standards were not efficient enough in crisis period and also restrictions and rules were so strict are found among these accusations. There is an advantage in providing flexibility in the application of standards in abnormal periods as financial crisis. Especially banks were canalized in the application of fair value while reporting their financial assets. It should not be forgotten that there is also a political pressure that directs standard setters.

After the financial crisis, IASB performed some relaxations related with the fair value accounting. These amendments are reclassification of some financial instruments and issuing guidance on measurement when markets become inactive and very thin (Amel‐Zadeh and Meeks 2013). In some situations, organizations are allowed to depart from fair value accounting (they may prefer historical cost).

Standards issued by IASB and related with structured finance are as follows:
  • IFRS 7 Financial Instruments: Disclosures and IFRS 12—Disclosure of Interests in Other Entities: The importance of this standard is that the insufficiency in disclosures of structured finance products is one of the main reasons that have an impact on financial crisis.

  • IFRS 9—Financial Instruments: This standard will supplant the IAS 39. IFRS 9 was issued in 2014 and will come into effect in 2018.

  • IFRS 10—Consolidated Financial Statements: In this standard in whose financial statements Special Purpose Entities may be reported and also how they may be shown is informed.

  • IFRS 13—Fair Value Measurement

  • IAS 39—Financial Instruments: Recognition and Measurement

All these debates have brought to mind a new question: Instead of fair value which valuation measure will bring to a successful condition? Frequently, historical cost is the answer of this question. It is important to remember that in valuation while historical cost accounting uses book values, fair value accounting depends on market values. In other words, historical cost is the monetary amount paid in the transaction. Fair value is the current market value. In this sense, generally historical cost equals to the fair value at the time assets are subject to transaction.

5 Conclusion

Fair value accounting is procyclical. For this reason, during boom periods assets write ups and especially banks’ leverage ratios increase, means high return on equity (ROE) appears. During crisis as a result of sharp decreases in market prices, company losses will appear. This situation causes a much more weak financial system and a sharper financial crisis. On the contrary, during boom periods historical cost accounting prevents asset write ups and provides lower leverage ratios (Laux and Leuz 2009a).

The proponents of fair value accounting defend that as a result of the application of this method, financial statements will be accurate and as they will reflect the current values in the market timely. So the transparency will increase. What we say may be the most important benefits of fair value accounting that cannot be ignored. There are also proponents of historical cost accounting and they oppose to the application of fair value accounting. They thought that fair value accounting leads to an artificial volatility and so in some cases, boom values may be seen. For these reasons historical cost accounting is much more useful according to them (Allen and Carletti 2008).

Each valuation method has its own positive and negative sides. In this tradeoff the main question must have the following: Is the accounting numbers well reflection of the market important for us? Or is the determination of the accounting numbers prudently against the negation that can be seen in market values in the future important for us? The global shock rekindles the debate that depends on these two questions. Currently, there is still no agreed upon answer.


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Copyright information

© Springer International Publishing AG 2017

Authors and Affiliations

  1. 1.Faculty of Economics and Administrative Sciences, Department of ManagementBaskent UniversityBaglicaTurkey
  2. 2.Faculty of Economics and Administrative Sciences, Department of International TradeGazi UniversityBesevlerTurkey

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