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common way to accomplish this was for the sponsor to agree to buy back the SIV’s asset-backed securitiesshould they become impaired. Also, SIVs could hedge their risk by purchasing credit default swaps (CDSs)These were derivative financial instruments that would reimburse the SIV for all or part of credit losses on itsABSs. To obtain this protection, the CDS purchaser paid a fee (called the spread) to the CDS issuer. The beliefthat credit losses on the underlying ABSs were protected increased the confidence of lenders that their loans tothe SIV were low risk.Note that if an SIV was consolidated into the financial statements of its sponsor, the high SIV leverage wouldshow up on the consolidated balance sheet. Now, sponsors will be penalized by the market if their leveragegets too high, even given the apparent safety of ABSs, since investors react negatively to increased risk. This isparticularly so for financial institutions, many of which are subject to capital adequacy regulations.Consequently, like Enron, firms that sponsored SIVs had an incentive to avoid consolidation of their SIVs intotheir own financial statements. Then, leverage could be further exploited by remaining off-balance sheet. Thismotivation would be reduced to the extent that the market looked through the lack of consolidation and valuedthe sponsor and its VIEs as one entity. Landsman, Peasnell, and Shakespeare (2008) report evidence that themarket did do this. Even so, avoiding consolidation would be of crucial importance to financial institutionsfacing capital adequacy regulations, since these are based on financial statements.As described above, standard setters had moved to tighten up the rules for consolidation.Crash of mortgage backed securities (MBSs)Nevertheless, sponsors were able to avoid consolidation, by creating expected loss notes(ELNs). Thesewere securities sold by sponsors to outside parties under which the purchasers committed to absorb a majorityof a VIE’s expected losses and receive a majority of expected net returns. Thus, the holder of the ELN becamethe primary beneficiary under FIN 46, and consolidation would be with the financial statements of the ELNholder, not with the sponsor. Freed from consolidation, the sponsor could then exploit VIE leverage as much asit wanted. Presumably, the balance of net returns would go to the sponsor. In addition, sponsors received feesfor various services rendered to VIEs.Beginning in 2007, this whole structure came crashing down, however. It had become increasingly apparentthat because of lax lending practices to stoke the demand for more and more MBSs to feed leverage profits,many of the mortgages underlying MBSs were unlikely to be repaid. As a result, a major advantage of ABSsfrom an investor’s perspective (diversification of credit risk across many similar assets) turned out to be theirgreatest weakness: asset-backed securities lacked transparency. This was particularly so for CDOs, whichtended not to be publicly traded. As concern about mortgage defaults increased, investors were unable to (or.
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Balance Sheet, Financial Accounting Standards Board, fair value accounting, ABSS