Corporate Taxes and Securitization

• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/jofi.12157
• Author: KWANGWOO PARK,JOONGHO HAN,GEORGE PENNACCHI
• Date: 01 June 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 3 •JUNE 2015

Corporate Taxes and Securitization

JOONGHO HAN, KWANGWOO PARK, and GEORGE PENNACCHI∗

ABSTRACT

Most banks pay corporate income taxes, but securitization vehicles do not. Our model

shows that, when a bank faces strong loan demand but limited deposit market power,

this tax asymmetry creates an incentive to sell loans despite less-efficient screening

and monitoring of sold loans. Moreover, loan-selling increases as a bank’s corporate

income tax rate and capital requirement rise. Our empirical tests show that U.S.

commercial banks sell more of their mortgages when they operate in states that

impose higher corporate income taxes. A policy implication is that tax-induced loan-

selling will rise if banks’ required equity capital increases.

PRIOR TO THE 2007 to 2009 financial crisis, securitization grew rapidly for sev-

eral decades.1Securitization is a process whereby banks and nonbank lenders

sell mortgages or other loans to special purpose vehicles that issue mortgage-

or asset-backed securities. Securitization permits a bank to originate loans

and then transfer their interest rate and credit risks to mortgage- and asset-

backed security investors. A potential benefit to the banking system is reduced

exposure to risks that threaten its stability. For example, banks that securitize

long-duration fixed-rate mortgages can avoid the extreme interest rate risk

that decimated U.S. thrift institutions during the 1980s. However, the recent

revelation of mortgage-backed securities’ poor credit quality has highlighted

problems with the securitization process.2

Academic research has long recognized that securitization can have detri-

mental side effects. Models such as those in Diamond (1984), Ramakrishnan

∗JoongHo Han is at Sungkyunkwan University, Kwangwoo Park is at the Korea Advanced

Institute of Science and Technology, and George Pennacchi is at the University of Illinois. We are

grateful for valuable comments from an anonymous referee, Adam Ashcraft, Mark Flannery, the

Editor Campbell Harvey, Edward Kane, Hayne Leland, Greg Nini, and participants of the 2010

Financial Intermediation Research Society Conference and of seminars at Bocconi University,

the Federal Deposit Insurance Corporation, the Federal Reserve Banks of Chicago and New York,

KAIST,KDI School, Seoul National University, Sungkyunkwan University,Tilburg University, and

the University of Venice.Hakkon Kim and Hyun-Dong Kim provided excellent research assistance.

1The total value of U.S. agency- and government-sponsored enterprise-backed mortgage pools

and private issue mortgage, consumer, and trade credit loan pools grew at average annual con-

tinuously compounded rates of 33.5%, 25.2%, 12.9%, and 11.6% during the decades 1967 to 1977,

1977 to 1987, 1987 to 1997, and 1997 to 2007, respectively. Source: Flow of Funds Accounts of the

United States, Board of Governors of the Federal Reserve System.

2Fender and Mitchell (2009) review the recent collapse of global securitization markets. Mian

and Sufi (2009)andKeysetal.(2010) provide additional discussion of securitization with a focus

on the U.S. subprime mortgage crisis.

DOI: 10.1111/jofi.12157

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1288 The Journal of Finance R

and Thakor (1984), and Rajan (1992) explain why a financial contract

resembling a bank is the most efficient means of funding borrowers whose

creditworthiness is not public information. The contract requires that a

bank’s owner-manager bear its loans’ credit risks to have the incentive to

efficiently screen loan applicants and monitor borrowers’ actions. If this credit

risk is transferred by selling (securitizing) a loan, the bank’s incentive to

credit-screen and monitor declines. While Pennacchi (1988) and Gorton and

Pennacchi (1995) show that loan sales contracts can be structured to mitigate

the moral hazard of reduced credit-screening/monitoring, whenever some risk

is transferred the bank’s equilibrium credit-screening/monitoring remains

suboptimal. Consistent with this theoretical prediction, Keys et al. (2010) find

that securitized pools of subprime mortgages had default rates that were 10%

to 25% higher than similar mortgages that were not securitized. Elul (2011)

and Jiang, Nelson, and Vytlacil (2014) present additional evidence consistent

with reduced screening of securitized mortgages.

If investors in mortgage- and asset-backed securities recognize the loan-

selling bank’s suboptimal credit-screening/monitoring, they should rationally

discount the value of securitized loans, forcing the bank to internalize this

inefficiency.Consequently, a bank’s decision to sell or retain a loan would weigh

the economic benefits of risk transfer against the economic costs of inefficient

screening/monitoring. However, as our paper points out, other factors largely

overlooked in the academic literature can play major roles in a bank’s loan-

selling decision.

Our paper is the first to model and empirically analyze how corporate taxa-

tion of a bank’s income and the competitive conditions in the bank’s loan and

deposit markets affect its incentives to securitize. The model assumes that a

bank can improve the returns on the loans that it originates by screening and

monitoring them. The bank can also invest in marketable securities and fund

loans and securities “on balance sheet” by issuing equity and inelastically sup-

plied deposits. Alternatively, it can fund loans by selling them to rational loan

buyers who recognize the bank’s equilibrium disincentive to screen/monitor

securitized loans.

The model produces novel results by deriving conditions under which a bank

will sell loans. It shows that, if a bank has limited loan origination opportu-

nities but significant deposit market power, it will not sell loans but instead

choose to invest its inexpensive excess deposits in securities. In contrast, a bank

with significant loan opportunities but limited deposit market power will not

invest in securities and may have an incentive to sell loans. Importantly, this

bank’s loan-selling incentive rises as its corporate income tax rate increases.

Furthermore, since the bank pays more corporate taxes when its equity capi-

tal ratio is higher, raising regulatory capital requirements also increases loan

sales. These greater loan sales come at the cost of less efficient screening and

monitoring of sold loans.

Though it is well known that corporate taxes create an incentive for ex-

cess leverage, it is not commonly recognized that corporate taxes promote

Corporate Taxes and Securitization 1289

securitization.3We show that tax-induced securitization occurs because of the

asymmetric tax treatment of on- and off-balance sheet financing.4While a bank

is subject to corporate income taxes, a special purpose vehicle that purchases

loans and issues mortgage- or asset-backed securities is corporate tax-exempt.5

Thus, corporate tax avoidance can lead to loan-selling despite the cost of ineffi-

cient screening and monitoring of sold loans.6We discuss how this corporate tax

wedge, along with greater deposit market competition, may have contributed

to the growth in securitizations and the defaults on securitized loans.

This paper also provides empirical evidence on corporate taxes and loan

sales. We analyze sales of mortgages by U.S. commercial banks using Home

Mortgage Disclosure Act (HMDA) filings for the period 2001 to 2008. The key to

identifying how corporate taxes affect mortgage sales is differences in corporate

tax rates imposed by state governments. State corporate tax rates vary from

zero to over 10%, and we use this variation to examine whether banks operating

in high-tax states tend to sell a greater proportion of the mortgages that they

originate.7We also refine this analysis by identifying those banks that are likely

to face high loan demand but limited deposit market opportunities, which are

the banks that our model predicts would be candidates to sell loans. This is done

using the proportion of a Metropolitan Statistical Area’s (MSA’s) population

that is below versus above age 65. As shown by Becker (2007), MSAs with

a younger population are markets with high loan demand and low deposit

savings. The reverse is true for MSAs that have a relatively high proportion of

seniors, who tend to have low loan demand but invest heavily in retail deposits.

Our empirical results support the model’s predictions. A bank operating

in a state that imposes high corporate income taxes tends to sell more of the

mortgages that it originates. This is particularly true if the bank operates in an

MSA with a young population and hence tends to experience substantial loan

3For example, Shaviro (2009) reviews how tax rules contributed to the 2008 financial crisis

by encouraging excessive corporate debt, derivative transactions, housing leverage, and poorly

designed incentive compensation schemes. But the tax incentive for excessive securitization is not

mentioned.

4Leland (2007) shows that unused tax deductions when net operating losses occur create a

corporate tax-minimizing incentive to place assets with different risks in particular corporate enti-

ties. This incentive can generate mergers, spin-offs, or asset securitizations. His analysis assumes

that different entities are taxed symmetrically, whereas our model accounts for the corporate

tax-exempt status of special purpose vehicles that hold securitized loans.

5Most U.S. special purpose vehicles are organized as limited liability corporations (LLCs). If

the LLC passes through all loan income to the mortgage- or asset-backed security investors, it is

exempt from corporate taxes. Of course, the income received by investors is subject to personal

taxation, but in a symmetric fashion so is the income received by a bank’s depositors and equity

holders. See Bank for International Settlements (2009).

6Lawyers recognize the importance of structuring securitizations so that special purpose vehi-

cles do not generate taxes. Peaslee and Nirenberg (2001, p. 2) state “a securitization transaction

almost certainly would not be viable if passing cash through the (special purpose vehicle) issuer

resulted in significant additional tax burdens. One of the main goals of tax planning in this area—

indeed the sine qua non—is to ensure that no such tax costs are incurred.”

7Ashcraft (2008) uses variation in state corporate tax rates to identify a bank’s choice of capital

instruments.