Interaction between Securitization Gains and Abnormal Loan Loss Provisions: Credit Risk Retention and Fair Value Accounting

• In Event: Banks, Loans, and Goodwill

Abstract

This study investigates whether managers use gains from asset securitizations to substitute or complement loan loss provision (LLP) management for smoothing earnings in the financial industry. Dechow, Myers, and Shakespeare (2010) provide evidence that managers have used securitization transactions to either boost or smooth earnings. Using 2001‒2014 data for a sample of publicly traded bank holding companies, I provide evidence that gains from asset securitizations are positively (negatively) associated with abnormal LLP when the percentage of credit risk retention of the securitized assets is greater (less) than one percent. Specifically, managers use securitization gains and abnormal LLPs as partial substitutes when the percentage of the risk retention is greater than a certain level. This finding is consistent with the argument that since discretion may be used in the expected default rate or discount rate assumptions to report the fair value of retained portions to yield higher or lower gains, the higher the percentage of risk retention, the more discretionary the securitization gains. Further, I find that managers do use the securitization gains neither to substitute nor to complement abnormal LLPs for banks only securitizing mortgages. This evidence is consistent with the conjecture that, because the market for mortgage backed securities is significantly larger and substantially more liquid relative to the other types of securitized loans, less discretion is available for bank managers to provide biased estimates of fair values of retained interests to smooth earnings. Taken together, these findings have implications for the credit risk retention requirements of the Dodd Frank Wall Street Reform and Consumer Protection Act (2010) and provide additional support for improved disclosures on assets backed assets recommended by Dechow et al. (2010).

Author

• Qiuhong Zhao, Texas A&M University - Corpus Christi