Some congressional leaders and commentators have blamed structured finance and special-purpose vehicles for the Enron mess. As a result, there is a movement afoot in Washington to try to curtail the use of structured finance products.
Such an initiative is short-sighted and counterproductive and can be premised only on complete ignorance of what structured finance is and how valuable it is to our economy. Structured finance is the process of breaking traditional financial instruments into their component risk and return parts, then reassembling them to create more attractive instruments for issuers and investors.
Products such as callable bonds and convertible bonds have been in use for a long time. More recent innovations — like mortgage-backed securities — involve the transfer of financial assets to a special-purpose vehicle, which in turn issues securities to investors.
When done properly, these transactions provide numerous benefits. They lower issuers’ funding costs by removing inefficiencies in the capital markets, and they enhance issuers’ liquidity by diversifying their funding sources and enabling them to monetize assets that would be difficult to sell outright.
For investors, the principal benefit is flexibility. Investments can be tailored to fit the desired risk profile of an investor. Since structured finance enables them to take on exposure to many types of risk in the form of securities — usually investment grade — that can easily be sold in the secondary market, investors, too, benefit from the increased liquidity. It also gives them the benefits of diversification by enabling them to take on exposure to aggregations of assets in ways that minimize risk.
Structured finance creates resources, facilitates the allocation of risk, and enables capital to be used more productively. Rather than limiting access to these essential and value-creating tools, policymakers should be focusing on how we can make them more transparent and how to increase understanding about the way they work.
I believe that there are four ways in which this can be done.
First, accounting procedures should be revised to reflect the change from book-value accounting to accounting based on economic principles. Users of structured finance should disclose all the information necessary to judge the risk and returns of their assets — including those in special-purpose vehicles. In a big step forward, some banks already have committed to offering structured financial products only when the proper balance-sheet information is disclosed.
Second, U.S. accounting rules and disclosure requirements should be harmonized with those of other countries. Investors’ ability to compare the financial statements of foreign and domestic entities is key to restoring confidence.
Third, accountants and regulators should become better educated on the use of structured finance. The infrastructure for this is already in place; it now must be used. Universities and professional associations can provide the necessary training to allow regulators and investors to stay up-to-date on Wall Street innovations.
Finally, over the long term, the fraudulent use of structured finance is best prevented by the development of social contracts between finance practitioners and the investing public. Ethics should be a central part of every business student’s education. Moreover, corporations need to make ethics the keystone of their cultures. As a matter of enlightened self-interest, top corporate executives should set an example for others to follow.
