Academic journal article Academy of Accounting and Financial Studies Journal

Special Purpose Entities and the Shadow Banking System: The Backbone of the 2008 Financial Crisis

Academic journal article Academy of Accounting and Financial Studies Journal

Special Purpose Entities and the Shadow Banking System: The Backbone of the 2008 Financial Crisis

Article excerpt

INTRODUCTION

In October of 2001, energy giant Enron spiraled quickly into bankruptcy following revelations of wide spread accounting fraud that hid enormous amounts of debt and losses. At the heart of this fraud was a web of accounting structures known as Special Purpose Entities (SPEs), which allowed Enron to exclude large amounts of debt from the company's balance sheet. Less than six years later, in March 2007, the failure of New Century Financial, the second largest sub-prime mortgage lender in the U.S., signaled the beginning of a financial crisis that would prove to be one of the worst in U.S. history. Once again, unanticipated losses residing in SPEs that were not included on the company's balance sheet catapulted the company into failure.

Over the last four decades, SPEs have evolved from an exotic financing structure that was used sparingly, to a complex vehicle that is at the center of the U.S. and global financial systems. While many of these structures are legitimate and offer a viable mechanism for distributing risk through the capital markets, their close association with financial crisis means that they can also be a tool for fraud and imprudent management. In the remainder of this article, we: (i) introduce the structure of special purpose entities, (ii) review the history of SPEs, (iii) explore their connection and contribution to structured investment vehicles (SIVs), and (iv) discuss their impact on the 2008 financial crisis.

SPECIAL PURPOSE ENTITIES

Gorton & Souleles (2007, p. 550) define a special purpose entity as "a legal entity created by a firm (known as the sponsor or originator) by transferring assets to the [SPE], to carry out some specific purpose or circumscribed activity, or a series of such transactions." A primary benefit of the SPE structure is its favorable accounting treatment, which is termed "off-balance sheet financing". If the sponsor meets certain criteria, the SPE will be treated as a separate economic entity for financial reporting purposes. This allows the sponsor to remove the assets and liabilities that are housed in the SPE from its (the sponsor's) balance sheet. Since most SPEs are highly leveraged, this reduces the sponsor's debt load relative to equity. As a result, the sponsor will likely achieve a higher credit rating, which reduces its overall borrowing costs. To achieve these desirable accounting results, an SPE has several essential characteristics:

1. It must be a separate legal entity from the sponsor,

2. The entity is "bankruptcy remote",

3. It is created to carry out a fairly specific activity, and

4. It is thinly capitalized, (i.e., heavily leveraged), with the residual equity ownership held by a third party other than the sponsor.

Each of these characteristics is necessary for the SPE to achieve its ultimate objective, which is to provide off-balance sheet financing for the sponsor. The first characteristic, the establishment of a separate legal entity, is necessary because the SPE will need to generate its own financial statements that are exempt from consolidation by the sponsor. This is only possible if the SPE has a legal form that is separate and distinct from the sponsor.

Second, the entity must be structured so that there is a remote chance that it will become bankrupt. This is typically accomplished by securing (or collateralizing) the debt issued by the SPE directly to the assets in the SPE. In addition, the debt issued by the SPE will typically be structured in such a way that creditors effectively "waive" their rights to force the entity into bankruptcy. When structured in this manner, the possibility that the SPE will go bankrupt is remote. A tangential issue, however, is that any assets transferred to the SPE must also be isolated from the sponsor in the event of the sponsor's bankruptcy. Only if the assets are beyond the reach of the sponsor's creditors can the transfer of the assets to the SPE qualify as a sale, with both the assets and associated debt treated as rights and obligations of a separate entity. …

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