1

Corporate Taxes and Securitization

The Journal of Finance

by

JoongHo Han KDI School of Public Policy and Management

Kwangwoo Park Korea Advanced Institute of Science and Technology (KAIST)

George Pennacchi University of Illinois

2

Introduction Ø  Until its recent crash, securitization grew tremendously over the last

few decades.

Ø  Securitization has risk management benefits: banks may transfer interest rate and credit risks to investors willing to bear them.

Ø  But securitization has harmful side effects. Transferring credit risk reduces a bank’s incentive to screen the credit of loan applicants and monitor borrowers (Pennacchi, 1988).

Ø  The current paper emphasizes that securitization may be excessive because it is also motivated by a desire to avoid corporate taxes.

Ø  Most banks must pay corporate income taxes but special purpose corporations that hold securitized loans do not.

3

Contribution of Paper Ø  A model is developed to examine the relationship between a

bank’s loan and deposit market power, its corporate income tax rate, and its incentive to securitize.

Ø  The model shows that if a bank has profitable lending opportunities but limited deposit market power, then its incentive to securitize increases as its corporate income tax rate rises.

Ø  Data from Home Mortgage Disclosure Act (HMDA) filings of commercial banks’ mortgage originations and sales during 2001 to 2008 are used to test the model’s predictions.

Ø  Variation in state corporate income tax rates and MSA demographics allows us to analyze the interaction of taxes, loan and retail deposit opportunities, and loan selling.

4

Outline

I.  A Model of Bank Loan Sales

II.  Empirical Evidence

III.  Conclusion

5

I. A Model of Bank Loan Sales I.A Assumptions Ø  (A1) Each period a bank faces multiple lending opportunities. A

one unit loan made to borrower i returns the cash flow of xi(s,ai) at the end of the period, where s∈S is the end-of-period state of nature and ai is the bank’s initial credit screening/monitoring.

Ø  (A2) xi(s,ai) is a weakly increasing and concave function of ai. The bank’s screening/monitoring is not verifiable and contractible by outsiders (loan buyers) and its (end-of-period) cost equals c×ai.

Ø  (A3) The bank is subject to a corporate income tax at rateτ and must meet a regulatory minimum equity (E) to deposits (D) ratio. This leverage constraint is given by κD ≤ E.

6

Assumptions (continued) Ø  (A4) pe(s) and pd(s) are initial prices of unit end-of-period

payments in state s for securities (personally) taxed as equity and debt. Certainty-equivalent competitive returns to equity and debt are re and rd, where 1/(1+ri) ≡ ∫S pi(s) for i = e, d. pe(s)/pd(s) is constant across states, equal to (1+rd)/(1+re). Also, rd(1-τ) < re.

Ø  (A5) The bank can invest in securities that have state-contingent returns and a certainty-equivalent rate of return of rd.

Ø  (A6) The bank has deposit market power and pays a certainty- equivalent deposit interest rate of rD = rD(D), where ∂rD/∂D ≥ 0.

Ø  (A7) The bank maximizes the after-tax return to shareholders’ equity. Deposits are fully insured with the bank paying an insurance premium that fairly reflects its default risk.

7

I.B The Bank’s Optimization Problem

Ø  Denote Nh (Nm) to be the number of loans that the bank holds (sells or markets) and let B be its investment in securities.

Ø  Let λf and λk be the Lagrange multipliers on the financing and capital constraints, respectively.

{ }( ) ( ) ( ) ( ) ( ){

}( )

1 1, , , , ,max 1 , 1 ,0 1

1

h m

h mi

N Ne h d me i i i ii iS SN N a B D E

d D e

r p s x s a ds ca p s x s ds

r B r D r Eτ

= =⎡ ⎤ ⎡ ⎤+ − − + −⎣ ⎦ ⎣ ⎦

+ − − −

∑ ∑∫ ∫

( ) ( )1

subject to

,0 1 financing

capital

mNh d mii S

N B D E p s x s ds

D Eκ=⎡ ⎤+ ≤ + + −⎣ ⎦

≤

∑ ∫

8

I.C Equilibria With No Loan Sales Market (Nm=0) I.C.1 Equilibrium with Excess Capital

Ø  With λk = 0, the tax-adjusted cost of financing equals

Ø  In this “Loan rich, deposit poor” equilibrium the bank has many profitable loans which are funded at the margin with excess equity.

Ø  Deposits are issued up to the point where their marginal cost equals the tax-adjusted cost of equity.

Ø  It is unprofitable for the bank to hold securities since rd < re/(1-τ).

1 1f eD

Drrr D

Dλ

τ τ∂

= + =− ∂ −

( ) ( ) ( ) ( )1 , 1 / 1h h he h

e eN N NSr p s x s a ds ca r τ+ − − = −∫

9

I.C.2 Equilibrium with Binding Capital and Security Investments

Ø  With λk > 0, the tax-adjusted cost of financing equals

Ø  If it is optimal for the bank to invest in securities, it must have limited lending opportunities but substantial deposit market power.

Ø  In this “Loan poor, deposit rich” equilibrium, λf /(1-τ) = rd and the marginal loan satisfies

11 1 1 1

f eDD

rrr DD

λ κτ κ κ τ

∂ ⎛ ⎞⎛ ⎞= + +⎜ ⎟ ⎜ ⎟− + ∂ + −⎝ ⎠ ⎝ ⎠

( ) ( ) ( )1 , 1h h he h

e dN N NSr p s x s a ds ca r+ − − =∫

10

I.C.3 Equilibrium with Binding Capital and without Security Investments

Ø  Another equilibrium with λk > 0 but where the bank holds no securities can be described as “Loan and deposit compatibility.”

Ø  In this equilibrium, the marginal cost of financing satisfies

Ø  A special case is a bank that has access to a perfectly elastic supply of competitively-priced brokered or wholesale deposits:

11 1 1 1

f ed

rrλ κτ κ κ τ

⎛ ⎞= + ⎜ ⎟− + + −⎝ ⎠

( )1 1f e

drr

λ

τ τ≤ ≤

− −

11

Summary: Equilibria Without Loan Sales Market

Ø  There are three types of equilibria:

1.  There is a “Loan rich, deposit poor” equilibrium where: Ø  Many profitable loans are funded at the margin with excess equity. Ø  Deposits are issued to the point where their marginal cost equals the tax-

adjusted cost of equity. Ø  It is unprofitable to invest in securities.

2.  There is a “Loan and deposit compatibility” equilibrium where: Ø  Loans are funded at the margin with equity and moderate cost deposits. Ø  Capital constraints bind; it is unprofitable to invest in securities.

3.  There is a “Loan poor, deposit rich” equilibrium where: Ø  Few profitable loans are originated. Ø  Equity and low cost deposits are invested at the margin in securities. Ø  Capital constraints bind.

12

I.D Equilibria with a Loan Sales Market Ø  If loan i is retained on the balance sheet, then ai

* satisfies

and the present value of the profit from holding the loan is

Ø  If, instead, the loan is sold, the present value of profit is

( ) ( )( )**

,1

hi ie

e Si

x s ar p s ds c

a∂

+ =∂∫

( ) ( ),0 1d miS

p s x s ds −∫

( ) ( ) ( )** 1 / 1

,1

i fd hi iS

d

cap s x s a ds

rλ τ+ + −

−+∫

13

Excess Profit of Holding versus Selling

Ø  The excess profit from retaining versus selling the loan is

Ø  The first term (integral) is unambiguously positive.

Ø  If the bank’s equilibrium is “Loan poor, deposit rich,” so that it invests in securities and λf/(1-τ) = rd, then the second term equals zero and there is never an incentive to securitize.

Ø  In this case, a marginal increase in the corporate tax rateτ has no effect on the incentive to sell loans.

( ) ( ) ( )( )* * / 1

, ,01

f ddi i i iS

d

rp s x s a ca x s ds

rλ τ− −

⎡ ⎤− − −⎣ ⎦ +∫

14

A Potential Loan Selling Equilibrium

Ø  If the bank’s equilibrium is “Loan rich, deposit poor,” so that it holds no securities and λf/(1-τ) = re/(1-τ), then the excess profit of retaining versus selling is

Ø  Since re/(1-τ) > rd, the second term is negative, so there could be a net advantage to selling the loan.

Ø  Importantly, the net advantage to loan selling is an increasing function of the corporate tax rateτ.

Ø  Similarly, an advantage to loan selling can exist for the “Loan and deposit compatibility” equilibrium if rd < λf/(1-τ) ≤ re/(1-τ).

( ) ( ) ( ) ( )* * / 1, ,0

1e dd

i i i iSd

r rp s x s a ca x s ds

rτ− −

⎡ ⎤− − −⎣ ⎦ +∫

15

Summary: Equilibria With Loan Sales

Ø  Proposition 1: A “Loan poor, deposit rich” bank will invest in securities, and a marginal increase in its corporate tax rate has no effect on leverage or its incentive to sell loans. A marginally higher tax rate or equity capital requirement decreases its securities purchased but not the quantity of loans held on its balance sheet.

Ø  Proposition 2: A “Loan rich, deposit poor” or “Loan and deposit compatibility” bank chooses not to invest in securities, and a marginal increase in its corporate tax rate increases its incentive to sell loans and can raise its leverage. A marginal increase in the bank’s equity capital requirement also raises its incentive to sell loans.

16

II. Empirical Evidence II.A Data

Ø  The data covers the period 2001-2008 and includes: 1.  Individual bank’s HMDA filings on mortgages originated and sold during each

calendar year. 2.  Call Report and Summary of Deposits data on C-Corp banks that have at least

90% of their deposits in a single state and a single MSA. 3.  State corporate income tax rates for each year from the Tax Foundation 4.  Census Bureau projections on each MSA’s proportion of “seniors” (aged ≥ 65)

for each year. Following Becker JFE 2007, this proxies for an MSA’s extent of being “loan poor, deposit rich.”

5.  Other MSA-level data on housing supply elasticity (Saiz (2010)), population growth, personal income growth, and unemployment.

Ø  The final sample has 12,175 bank-year observations.

17

Mortgage Sales Ratio

Ø  Our main variable of interest is the Mortgage Sales Ratio, MSR:

Ø  We also differentiate between non-jumbo mortgages and jumbo mortgages, since the former may be easier to sell (to GSEs).

Value of mortgages that were originated and sold during the yearValue of mortgages that were originated during the year

MSR =

18

II.B Summary Statistics

19

Summary Statistics (Continued)

20

II.C Univariate Tests

21

II.D Multivariate Tests Ø  To test the proposition that higher corporate taxes lead to loan

sales at low security banks, we run the following Tobit regression:

where is an indicator variable that equals 1 if the bank’s MSA population has a proportion of seniors (aged ≥ 65) below the median.

Ø  Our model predicts that the sum of the coefficients a1 and a2 should be positive.

1 2 Seniors Median 3 Seniors MedianTaxRate TaxRate Bank Controls MSA Controls Time EffectsMSR a a I a I< <= + × +

+ + +

Seniors MedianI <

22

Tobit Analysis of Mortgage Sales Ratio

23

Analysis of Mortgage Sales Ratio: Robustness

24

Tobit Analysis: Senior Population Subsamples

25

Fama-MacBeth Regressions: Low Senior Sample

26

Regressions of Annual Changes, ΔMSR

27

Interpreting the Results

Ø  The results imply:

Ø  Higher corporate tax rates have little effect on mortgage sales for banks in high senior “loan poor, deposit rich” MSAs.

Ø  A one standard deviation increase in the corporate tax rate (1.88%) increases the mortgage sales of banks in low senior “loan rich, deposit poor” MSAs by 24.6%.

Ø  Mortgage sales increase with a bank’s size.

Ø  Non-jumbo mortgages are more likely to be sold and their sales are more sensitive to corporate taxes than are jumbo mortgages.

28

III. Conclusions and Policy Implications

Ø  Corporate taxes lead to greater (excessive?) loan selling for banks with substantial lending, but limited retail deposit, opportunities.

Ø  This implication most likely extends to larger, multistate banks and non-bank lenders (e.g., finance companies).

Ø  Reforms to strengthen capital standards and/or deposit insurance may increase the tax incentive to securitize, leading to less credit screening and monitoring by banks.*

Ø  Similarly, recent proposals to levy new taxes on banks may be counter-productive due to the asymmetric tax treatment of banks versus special purpose corporations.

* Higher capital requirements are claimed to cause French banks to begin securitizing. See “French Banks Try an Import from U.S.” Wall Street Journal Nov. 6, 2012.