Special Purpose Entity & Bankruptcy in Banks

SPEs can be exploited by banks and other corporations.

A U.S. bank under threat of bankruptcy could use special purpose entities -- essentially dummy companies created to own assets that a corporation does not want on its balance sheets -- as a lifeline, but this would be illegal.

Significance

A bank becomes bankrupt when it cannot pay its debt obligations. A bank under danger of bankruptcy might transfer debt to SPEs, with intent to hide debt from shareholders of the company, which misleads investors and violates financial regulations. A bank can legally transfer debt to SPEs, however, if the debt stems from purchased mortgage loans the bank will later resell to investors.

History

SPEs first gained notoriety in 2001, when the Enron Corp., with help from several investment banks, used SPEs to hide billions in debt from failed projects. Regulations were toughened thereafter, to better protect investors from corporate bankruptcy. In 2007, widespread U.S. mortgage defaults led to bankruptcy in investment banks unable to resell the mortgage loans from their SPEs.

Future

Ongoing changes to accounting standards have made it harder and costlier for banks to transfer mortgage loans to SPEs. According to the Financial Accounting Standards Board, new standards strengthened the rules relating to SPEs and enhanced disclosure requirements.

References

• CNNMoney.com: Off Balance Sheet -- and Out of Control
• CNNMoney.com: Citi agrees to pay $1.7B in Enron deal
• Financial Accounting Standards Board: FASB Statement 166 and 167