Some of the highest profile financial scandals in recent decades share an underlying deal structure whose recurring role in catastrophic business failures went undetected for 30 years, according to new scholarship by University of Pennsylvania Law School Professor William W. Bratton.
In a forthcoming law review article, Bratton and co-author Adam J. Levitin of the Georgetown University Law Center identify a common thread in financial scandals dating from Michael Milken’s junk-bond transactions during the 1980s through the collapse of mortgage-backed securities in the recent financial crisis. They argue that what appear to be highly novel transactions are actually variants with a family trait in common: they all make use of a corporate structure called a “Special Purpose Entity,” which acts as a company’s “alter ego,” even as it enters into apparent arm’s length transactions with the company.
The article, “A Transactional Genealogy of Scandal: From Michael Milken to Enron to Goldman Sachs,” is available as a working paper from the Institute for Law and Economics and will be published by the University of Southern California Law Review.
Bratton, an expert in corporate finance, is Deputy Dean and Nicholas F. Gallicchio Professor of Law at Penn, where he co-directs the Institute for Law & Economics. He spoke to Penn Law recently about his research and its implications.
Penn Law: Can you tell us how you came to write this article?
William Bratton: In 2009, there was a spate of books about the financial crisis. One of them, by Gillian Tett, a well-known financial journalist, described a transaction structure devised at the Morgan Bank in 1997—the first synthetic securitization, then called a “Broad Indexed Securitized Trust Offering” or “BISTRO.” I was unfamiliar with the deal, and given what I teach I found my lack of familiarity disturbing. So I gave the book my utmost attention. Tett is a very knowledgeable and talented writer. But in the end she never managed to explain the economic dynamics of the deal so that I felt confident that I understood them. I wasn’t sure whether the fault lay with the writer or the reader and the matter ended there.
Then, in 2010, the Goldman Abacus scandal occurred, and along with everybody else in the world I read daily reports about the Abacus transaction in The Wall Street Journal and The New York Times. I got a sense of déjà vu. I had seen the deal before in Tett’s book. I also had an epiphany. It hit me that I already had written about this deal structure back in 2002 in a paper on the Enron scandal. So, this 1997 Morgan deal had two notorious offspring each of which imparted impetus to important regulatory reform. I thought it might be interesting and worthwhile to connect the dots between the original deal structure and the subsequent scandals.
Once Adam Levitin joined the project we decided to project backwards in time to before 1997 and discovered the ultimate origin point at the Drexel office in Beverly Hills in the late 1980s. The tie that binds all the elements of the story is the fact that the structure had the effect of confusing people every time someone used it and financial disaster eventually resulted. If I found it confusing, I figured everybody else had too and that confusion and nefarious goings on were directly connected.
PL: How could a financial structure in use for that length time remain so obscure to so many people, including corporate finance scholars?
WB: There are many reasons. One is complexity. Over the last 20 or 30 years, financial technicians – bankers, lawyers, accountants – have found it worthwhile to construct opaque and confusing transactions for the purpose of getting regulatory or accounting relief. The only people with an incentive to invest the time and effort to achieve full understanding are the people paid to make the deals or work out the accounting for them.
Another reason is the imbalanced playing field between companies and their regulators and other outside observers. The companies have more resources than do the regulators, so that in the ordinary course of things regulation lags. Innovative transaction structures are created and the regulation catches up sporadically, usually in the wake of financial disaster. Academics tend to be even farther away. If you read policy discussions of bank capital regulation from before 2008, “off balance sheet” transactions might be identified as a problem, but there will be no useful further discussion.
PL: What was the hidden thread linking these scandals?
WB: The article focuses on off balance sheet transactions using Special Purpose Entities. It highlights the strategic use of these corporate alter egos facilitated by technocratic obfuscation. SPEs are suspicious because no one quite understands what they are.
PL: Can you explain further?
WB: SPEs are entities that are created by operating companies for the purpose of either purchasing assets from themselves or entering into other transactions with themselves such as credit default swaps. SPEs are not financed with a judicious mix of debt and equity, as occurs with traditional companies. Instead the capital is all or almost all debt, which causes SPEs to have distinct economic characteristics. In many cases, the particular value of the SPE lies in the fact that its assets and obligations are not required to be consolidated on the balance sheet of the operating company that creates it. The SPE enables the company to get assets and liabilities off of its balance sheet in transactions that it controls and that are not at arm’s length even as the system treats the transactions as if they were at arm’s length. That heads I win tails you lose aspect makes SPEs intrinsically suspicious.
PL: Are deals involving SPEs intrinsically harmful?
WB: No. Many transactions built around SPEs are perfectly all right. Take for instance a garden variety asset securitization: a bank takes a bunch of mortgages it originated and sells them to an SPE that it creates. The SPE gets the money to buy the mortgages by selling its own notes in the marketplace. The buyers of the notes take the risk of default on the mortgages. When the deal closes the mortgages go off of the bank’s balance sheet, but that’s OK because the bank is getting paid for them and the credit risk has been completely transferred to the holders of the SPE’s notes. From an accounting point of view, treatment of the transaction as a sale is perfectly acceptable. There are plenty of things that can go wrong in the mortgage securitization process, as we learned from the subprime debt crisis. But the setup is not intrinsically unsound.
PL: So how do problems arise?
WB: The asset securitization process stoked the subprime mortgage bubble. Analysts at the banks, the bond buyers, and the credit rating agencies employed a theory of portfolio diversification that purported to show that by transferring a bunch of subprime mortgage paper in an entity financed with the right package of senior and subordinated notes you really could take junk and turn it into gems. Financial alchemy. Something for nothing. It worked for a while, but only so long as real estate prices continued to climb. It was the faulty financial analysis that made the deals problematic, not the transaction structure. You can build a house well so that it stands up, or you can build it badly so that it collapses. The fact that a badly constructed one collapses doesn’t mean houses are bad.
What our article suggests is that SPEs are particularly prone to shoddy construction because they are opaque and behave in unexpected ways. Some of their designers have taken advantage of the fact that people expect certain things when they see a business entity. They constructed SPEs to play into those expectations even though the SPE’s economics work very differently and the regulatory structure accordingly needed to be rethought from the ground up.
PL: Is better regulation the solution?
WB: Many critics of financial regulation argue that you always get a bad result when regulators take the occasion of a financial disaster to draft new regulations. The new law is either badly thought through or the new constraints are just excessive. And that has been known to happen. But I don’t buy the critique as an absolute. The paper argues that this is a subject matter on which new regulation has been badly needed for a long time but that there was no way we were ever going to get it until a financial disaster occurred. In fact it took multiple financial disasters—Enron plus the financial crisis—before somebody in a position of responsibility focused on the problem and thought it through for the first time.
PL: Do we now have the regulation we need?
WB: Yes and no. We have regulation addressed to a series of financial disasters that assures that those particular events will not occur again. And that’s probably enough for now. The financial sector is still in retreat in the wake of the collapse of 2008. As a result, I doubt there is much in the way of structural financial innovation occurring on Wall Street right now. But once we have a new round of economic expansion, and I hope that is very soon, I think it’s safe to predict that new transaction structures will be created, and that one of the motivations for the creation of these transaction structures will be the gaming of the regulations that were redrafted in the wake of 2008. SPEs will still be there and I suspect they will be used again to permit operating companies to show higher returns and obscure the accompanying risks.
PL: So there’s no avoiding financial crisis?
WB: One can only avoid crises by forcing actors in the marketplace to take on less risk. The consensus view is that we’re better off stumbling from crisis to crisis than we are choking off risk taking.
PL: Is that your view?
WB: I am a financial conservative, meaning that I think many enterprises run excess risk, and if I were in a position to tell everybody what to do I would constrain risk taking more tightly than our present financial regulators are in a position to do. Bank equity capital? I’d open the bidding with a 20% cushion, no exceptions. But there are very few financial conservatives. It’s thought to be very old-fashioned.
PL: When you teach this subject matter, what lessons do you hope your students will learn?
WB: My students learn that high returns imply high risks. They study a lot of cases where the latest innovation purported to break the iron law of risk and return and offer high returns for minimal risk, causing things to go very wrong and resulting in externalities at the expense of society in general. In the course of that, they learn the role that lawyers play in making these things happen. They also learn how to protect those who part with their money in exchange for debt securities.
PL: So they won’t repeat those mistakes?
WB: The mistakes will be repeated, but not by my students.