1 Corporate Taxes and Securitization by JoongHo Han KDI School Kwangwoo Park KAIST George Pennacchi University of Illinois Dec 2010

 Until its recent crash, securitization grew tremendously over the last few decades.  Securitization has risk management benefits: banks may transfer interest rate and credit risks to investors willing to bear them.  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).  Most banks must pay corporate income taxes but special purpose corporations(SPCs) that hold securitized loans do not. 2 I. Introduction

 A model is developed to examine the relationship between a bank’s loan and deposit market power, its corporate income tax rate, and the bank’s incentive to securitize.  The model shows that if a bank has profitable lending opportunities but limited deposit market power, then it will have a greater incentive to securitize loans as its corporate income tax rate rises.  Data from over 4,000 commercial banks during 2001 to 2008 is used to test the model’s predictions and our results are consistent with the model’s predictions. 3 In Our Paper,

 The current paper emphasizes that securitization may be excessive because it is also motivated by a desire to avoid corporate taxes, precisely, the state corporate income taxes.  Variation in state corporate income tax rates allows us to analyze the relationship between taxes and loan selling incentives thereby offering an alternative explanation for the recent US credit crisis.  Future research can be directly toward how differential state corporate taxation can affect profitability of banks and thrifts in different states. 4 What can be contributed in the banking literature?

II.A Model of Bank Loan Sales III.Empirical Evidence IV.Conclusion and policy implications 5 Outline

II.The Model II.A. Assumption (A1) Each period a bank faces multiple lending opportunities. One unit loan borrower i returns the cash flow of x i (s,a i ) where s is the end-of- period state of nature and a i is the amount of credit screening and/or monitoring that the bank performs on the borrower (A2) The amount of credit screening/monitoring improves loan payments such that x i (s,a i ) is a weakly increasing and concave function of a i. Credit screening/monitoring is costly for the bank, equal to c  a i where c is a constant marginal cost incurred at the end of the period. (A3) The bank is subject to taxation of its income at the corporate tax rate . It also must meet a regulatory minimum equity to deposit ratio. E : bank’s total amounts of equity d: deposit (debt) financing. The leverage constraint is given by  D ≤ E.

II.A. Assumption (A4) Due to differences in personal taxation or investor clienteles, the competitive state prices of equity and debt claims may differ. p e (s) and p d (s) be the beginning-of-period prices (densities) of unit end-of- period payments in state s for securities that are equity and debt, (A5) A bank can invest in securities that have state- contingent returns. Securities differ from loans in that screening and/or monitoring by the bank does not increase the securities’ returns. (A6) Due to imperfect competition in deposit markets, the interest rate that a bank pays on its deposits may differ from the certainty-equivalent rate r d. r D = r D (D), where  r D /  D ≥ 0 : a bank needs to raise its deposit interest rate in order to attract additional deposits.

II.A. Assumption (A7) A bank’s objective is to maximize the after-tax return to its shareholders’ equity. Deposits are assumed to be fully insured at a premium that fairly reflects the deposit insurer’s losses due to the bank’s risk of failure. Monitoring 1)improves the returns on loans 2) is the most cost efficient manner Loan Sales are assumed without recourse.  Banks retains no risk

 Denote N h ( N m ) to be the number of loans that the bank holds (sells or markets) and let B be its investment in securities.  Let 1 and 2 be the Lagrange multipliers on the financing and capital constraints, respectively.  1 st Order Kuhn-Tucker conditions are written in equations (4)-(9) 9 II.B The Bank’s Optimization Problem

 If the bank’s equilibrium is “Loan rich, deposit poor,” so that it holds no securities and 1 /(1-  ) = r e /(1-  ), then the excess profit of retaining versus selling is  Since r e /(1-  ) > r d, the second term is negative, so there could be a net advantage to selling the loan.  Importantly, the net advantage to loan selling is an increasing function of the corporate tax rate .  Similarly, an advantage to loan selling can exist for the “Loan and deposit compatibility” equilibrium if r d < 1 /(1-  )  r e /(1-  ). 10 A Potential Loan Selling Equilibrium

 Comparing the “Loan rich, deposit poor” equilibrium with a loan selling market versus that without a loan selling market: 1.Allowing loan sales can increase the total amount of loans originated. 2.Allowing loan sales can decrease the bank’s excess capital, though it may still hold some excess capital. (c.f., Minton, Sanders, Strahan, 2004)  Proposition: For banks that invest in securities, a marginal increase in the corporate tax rate has no effect on leverage or the incentive to sell loans. A higher tax rate decreases securities purchased but not the quantity of loans held on balance sheet. For banks that do not invest in securities, a marginal increase in the corporate tax rate increases the incentive to sell loans. 11 Model Implications

 Similar to Jiangli, Pritsker, and Raupach (2007), we use Call Report data on banks’ servicing of loans for others and servicing of loans securitized by the bank to proxy for loan sales: 1.Mortgages (1-4 family residential) 2.All Other Loans (non-mortgage loans)  In addition, we collect survey data from Home Mortgage Disclosure Act (HMDA) filings.  “Call Report sample” allow us to construct “stock” mortgage sales to mortgages originated ratios, while “HMDA sample” provides “flow” mortgage sales to mortgages originated ratios. 12 III. Empirical Evidence III.A Data

 We also collect each bank’s (on balance sheet) mortgages, other loans, assets, securities, interest expense/deposits, HHI (from FDIC Summary of Deposits).  To identify a bank’s total (federal plus state) corporate income tax rate (Tax Foundation), the sample is limited to C-corp banks that have over 90% of their deposits issued in a single state.  S amples are limited to banks with single-state operations  Data on state unemployment (BLS), personal income growth (BEA), and population growth (BC) are also collected. 13 III. Empirical Evidence III.A Data

Summary Statistics 14

Summary statistics (conti.) 15

Univariate tests (conti.) 16

III.C Multivariate Tests 17  To test the proposition that higher corporate taxes lead to loan sales at low security banks, we run the following Tobit regression  Our model predicts that the sum of the coefficients a 1 and a 2 should be positive.

Table 4 Call Report Sample Results

Table 5 HMDA Sample Results

Table 6 Robustness Tests with HMDA Sample

 The estimates imply:  A 1% increase in the corporate tax rate increases the mortgage loan sales ratio of low security banks by about the same percentage (Call) or more than 1% (HMDA).  A 1% increase in the corporate tax rate increases the other loan sales ratio of low security banks by above 3%.  Bank size (ln(Assets)) is a significant determinant of loan selling. 21 Interpreting the Results

 The estimates also imply:  Sales of other loans increase with rises in deposit interest rates and state population growth.  Sales of mortgages increase with declines in deposit interest rates, population and personal income growth, and rises in unemployment. (c.f, Mian and Sufi (2009)) 22 Interpreting the Results

 Corporate taxes lead to greater (excessive) loan selling at low security banks with greater lending opportunities.  This implication most likely extends to larger, multistate banks and non-bank lenders (e.g., finance companies).  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. 23 Conclusions and Policy Implications