1. 1 Asset securitization, information asymmetry, and insider trading Ying Zhou Jennifer Wu Tucker June 2011

2. Research Question Do insiders take advantage of the information problem related to asset securitizations?

3. Terminology Asset securitization Recourse ◦ Explicit recourse (retained interest) ◦ Implicit recourse Risk transfer Information asymmetry ◦ Bid-ask spreads ◦ Analyst disagreement Insider trading

4. Asset securitization “Assets”: financial assets of a company (say, bank), such as mortgage loan receivables, other consumer loan receivables, and commercial loan receivables Securitization: the company sells a pool of assets to a special purpose entity (SPE), where the SPE raises cash to purchase the assets by selling debt securities to investors

5. Issuer (bank) Cash Loan receivables Servicing right SPE cash ABS (debt securities) ABS investors Bank investors Asset Securitization

6. Economic benefits of asset securitization Better asset portfolio diversification Higher level of liquidity Lower leverage indicated by the balance sheet Lower cost of capital because the SPE can typically raise funds at a lower rate due to lower expected bankruptcy cost

7. Recourse ABS investors are concerned that the original loan receivables may go bad The originating bank (issuer) provides some types of guarantees. Such guarantees are called “recourse.” Also referred to as “credit enhancement tools” ◦ Explicit recourse: contractual. Retain the lowest tranch of the asset-backed debt securities ◦ Implicit recourse: not obligated but expected

8. Therefore, securitizations Delink and repackage the risk and value of the securitized assets ◦ securitized assets=transferred interests + retained interests ◦ retained interests that concentrate the credit and other risks of the securitized assets are similar to derivatives ◦ A securitization has features of both a sale of the assets and a secured borrowing through the debt securities issued by the SPE ◦ The pool of securitized assets varies, the types of debt securities vary, and the recourse terms vary from securitization to securitization – very complex!

9. Financial reporting and disclosure of asset securitizations Financial reporting approaches: ◦ Control and component approach: SFAS 140 and 156 ◦ Risk and reward approach: IAS 39 Companies prefer sale accounting rather than secured-borrowing accounting Disclosure: ◦ The concern was “inadequacy” New reporting and disclosure requirement: ◦ SFAS 166 and 167 since 2010 Q1

10. Information uncertainty and information asymmetry The information uncertainty is regarding the amount and the extent of risk transfers in a securitization Serious information asymmetry between insiders and outside investors, even if the outside investors are sophisticated institutions

11. Opportunities for insider trading Cheng et al. (2011 TAR) find that high information uncertainty at securitizing banks ◦ Bid-ask spreads ◦ Analyst disagreement Insiders are in the best position to understand the implications of the securitizations to the bank Insiders are top managers, directors, and large investors of ownership of at least 10%

12. Data U.S. bank holding companies 2001Q2 to 2007Q2: 25 quarters Accounting data from the regulatory Y-9C reports that BHCs file quarterly with the Federal Reserve Returns data from CRSP Insider trading data from Thomson Financial

13. Empirical design Log(ISTRADE) = a 0 + a 1 SECURITIZE + a 2 SIZE + a 3 TURNOVER + a 4 | Δ ROA| + a 5 logMB + a 6 PASTRET + a 7 FUTURERET + e Dependent variables also use ISPURCH and ISALLTRADE Explanatory variables, SECURITIZE, are: (1) SAD (2) SA (3) SMA, SCONA, and SCOMA

14. Descriptive statistics

15. Primary analysis

16. Conclusion Although financial products facilitate risk transfers and resource allocations in the capital markets, some are extremely complex and existing financial reporting and disclosure are innately inadequate The opaqueness provides company insiders opportunities to benefit from their timely private information We find that insiders are unusually active at banks with active asset securitization activities, suggesting that a consequence of using such a financial engineering vehicle is to open doors for insider trading