Financial Law Links

8/8/2019 Financial Law Links

1/5

Commercial Paper Chase

If banks have to come clean about their off-balance-sheet leverage, get

ready to pay more for money.

Andrew Osterland - CFO Magazine

June 1, 2002

The structured-finance geeks on Wall Street used to ply their trade in relative obscurity.Not anymore.

The annual Bond Market Association meeting in New York on April 25 drew four timesthe audience it did last year. Such speakers as Treasury Secretary Paul O'Neill, Securitiesand Exchange Committee chairman Harvey Pitt, and capital-markets mainstay Paul

Volcker undoubtedly helped the turnout, but a swarm of reporters also turned up to askquestions about special-purpose entities (SPEs) and other means of moving risk offcorporate balance sheets. The media, of course, were looking for the next Enron.

Related Articles

Will Governance Metrics Catch On? Pensions as Earnings Drag? S&P Unveils New Earnings Gauge Reining In SPEs

"How do we help the market distinguish between what we do and what Enron did?" oneassociation member asked Pitt. He had no ready answer. The off-balance-sheet genie isout of the bottle, and for the time being there's no easy way to put it back in. With theFinancial Accounting Standards Board (FASB) currently deliberating on new rules forconsolidating SPEs and disclosing off-balance-sheet activities, structured finance is in thespotlight. Even if regulators don't curb the activities, the hue and cry from investors islikely to keep it there.

The activities conducted through SPEs in the asset-backed securities market may indeedbe a far cry from what Enron did, but they raise the same issues of disclosure and hiddenrisk. And given that more than a trillion dollars of assets were taken off corporate balance

sheets last year and put into SPEs and vehicles known as commercial-paper conduits, theissue may extend beyond comparisons to Enron.

The subjects of greatest concern are the commercial banks. They use SPEs to securitizetheir own assets, and also sponsor asset-backed commercial-paper conduits, whichpurchase and securitize assets from third parties. New accounting rules for these activitieswill cost both banks and their corporate borrowers. "All the major banks sponsor CPconduits," says Jeff Allen, a senior manager with PricewaterhouseCoopers. "If they are
http://www.cfo.com/index.cfm/l_emailauthor/3004888/c_3046524/2984983http://www.cfo.com/article.cfm/3005096?f=relatedhttp://www.cfo.com/article.cfm/3004736?f=relatedhttp://www.cfo.com/article.cfm/3004688?f=relatedhttp://www.cfo.com/article.cfm/3004484?f=relatedhttp://www.cfo.com/index.cfm/l_emailauthor/3004888/c_3046524/2984983http://www.cfo.com/article.cfm/3005096?f=relatedhttp://www.cfo.com/article.cfm/3004736?f=relatedhttp://www.cfo.com/article.cfm/3004688?f=relatedhttp://www.cfo.com/article.cfm/3004484?f=related


2/5

forced to consolidate them, there are going to be a lot more assets on their balancesheets." And probably a need for more capital to meet regulatory reserve requirements. Inthat case, banks and near-banks may be compelled to rein in their SPEs and conduitprograms, and the terms for both loans and asset-backed commercial paper would tighten.Moreover, without the liquidity guarantees provided in bank-sponsored conduits, many

companies might lose their access to the asset-backed market altogether. Can you say"credit crunch"?

Know-Nothings

At stake for the business community is the ability to make illiquid assets liquid bypackaging them into securities the most significant innovation in the capital markets inthe past two decades. Since Fannie Mae and Freddie Mac got the ball rolling in themortgage market as part of their mandate to foster home ownership in America,securitization has expanded into a variety of markets, including credit-card debt, auto andhome-equity loans, commercial mortgages, and trade receivables. The practice allowsoriginators to sell assets from their balance sheets and devote their capital to generating

new business. The good thing about securitization is that it has enabled the extension ofcredit to far more individuals and businesses in the United States. The bad thing aboutsecuritization is that financial-reporting practices haven't kept up with the innovation.Because the programs are executed in SPEs off-balance-sheet, investors know next tonothing about the risks involved in the activities.

"The banks are a lot more leveraged than we think," says Ohio State University professorof finance Anthony Sanders. "If they fully disclosed their risks, some people would betelling them to pare back their exposure." Indeed, some people, notably PacificInvestment Management Co. (PIMCO) bond fund manager Bill Gross, are already doingso. The heaviest hitter in the bond market recently accused General Electric of using off-

balance-sheet activities to manipulate its reported earnings, and also suggested that thecompany's heavy dependence on the short-term commercial paper market was becomingprecarious. GE CFO Keith Sherin has indicated that the company will reduce the liquiditysupport it provides for its commercial-paper conduits, and the company has begunrefinancing its debt structure in favor of longer maturities.

As the biggest players in the structured-finance market, commercial banks in the UnitedStates and Europe may have to do the same or more. A recent study of securitizationprograms by Standard & Poor's showed that all the major banks, and many minor ones,conduct significant off-balance-sheet securitizations through their own SPEs and throughcommercial paper conduits. Conduit programs alone financed approximately $500 billionin assets last year none of which appeared on corporate or bank balance sheets. Notmuch appeared in the footnotes, either. While Citigroup devoted some ink in its 2001annual report to its securitizations of credit-card debt, it revealed next to nothing aboutthe performance of $51 billion in assets residing in Citigroup-sponsored commercialpaper conduits and other securitization structures.

While securitization has enabled banks to finance assets through the capital markets, theprocess hasn't eliminated the risks associated with those assets. In fact, in most cases,


3/5

banks and asset-sellers have retained the majority of the risk of assets transferred off-balance-sheet. The process works fine when the economy is strong and credit losses aresmall, as was the case through most of the last decade. And to hear the bankingcommunity tell it, the asset pools serving as collateral for asset-backed bonds are stillperforming well. But no one knows for sure.

Commercial Paper Chase

(continued)

"We're comforted somewhat by the fact that regulators are looking at these thingsclosely," says S&P bank-rating analyst Tanya Azarchs. Indeed, in January, the SEC andthe Federal Reserve Board forced PNC Bank to consolidate distressed loans it hadtransferred into three SPEs. The result was a $155 million hit to PNC's first-quarterearnings.

FASB is determined that investors should be looking at these things more closely as well.Under current rules regarding SPE accounting, neither financial-services firms nor othertypes of businesses need disclose much about their off-balance-sheet activities. Even therating agencies have to essentially take banks at their word about the performance of theassets in their SPEs and conduits. If the economy's uncertain recovery falters, or aSeptember 11like event shocks the market again, the portfolios are almost certain todeteriorate. Now, says Sanders, is the time to be providing details about risk exposuresand potential liabilities. "I shudder to think of the litigation they may face if they don'tstart disclosing things now," he says. "If they keep this game going, there could be amassive Wall Street panic down the road."

Immortal Risk

Alarmist? Perhaps, but Sanders has a point. No matter how finance engineers slice anddice it, risk cannot be extinguished, it can only be transferred or redistributed. In the assetsecuritization process, companies create a hierarchy of different securities or tranches with varying degrees of credit risk associated with a pool of assets. The tranchesproduced in a typical asset-backed deal range from AAA credits down to BB.

Related Articles

Will Governance Metrics Catch On?

Pensions as Earnings Drag? S&P Unveils New Earnings Gauge Reining In SPEs

The investor community certainly loves the practice. With the federal government issuingless debt, and only a handful of corporations still holding a AAA credit rating, highlyrated, asset-backed paper is an easy sell with institutional investors. That's whysecuritization can lower the cost of capital for companies, say proponents.
http://www.cfo.com/article.cfm/3005096?f=relatedhttp://www.cfo.com/article.cfm/3004736?f=relatedhttp://www.cfo.com/article.cfm/3004688?f=relatedhttp://www.cfo.com/article.cfm/3004484?f=relatedhttp://www.cfo.com/article.cfm/3005096?f=relatedhttp://www.cfo.com/article.cfm/3004736?f=relatedhttp://www.cfo.com/article.cfm/3004688?f=relatedhttp://www.cfo.com/article.cfm/3004484?f=related


4/5

But in most cases, the originator of the asset whether it is a manufacturing companyfinancing trade receivables or a specialty finance lender securitizing loans retains aresidual interest in the performance of the assets. This interest obligates the issuer tocover losses in the asset pool up to a certain percentage. If losses exceed that percentage,other low-rated, subordinate tranches of the issuance begin to absorb them. "The post-

Enron fear is that there's all sorts of stuff out there we didn't know existed," says Azarchs."Now you wonder about what you don't know." Not exactly a confidence booster forinvestors. The billion-dollar question is, who holds those subordinate tranches?

With riskier slices of asset-backed securitizations harder to sell these days, the answer is,fewer and fewer investors. In many cases, collateralized debt and bond obligation (CDOand CBO) vehicles, many of them sponsored by European banks such as ABN Amro andDeutsche Bank, buy the lower tranches. CDOs and the like control about $400 billion inassets. Again, however, no one knows for sure. "It's all innuendo and rumor," saysAzarchs. A particularly troubling possibility is that the banks are scratching one another'sbacks. "It may be that a given financial institution has held not its own subordinate

tranches, but similar ones in deals sponsored by others," wrote Azarchs in a recent report.

The risks for banks don't end there. The banks also agree to provide liquidity support ifcash flow from the conduit isn't enough to pay off the paper as it matures. If enough loansin a conduit go bad, the sponsor bank could be liable. That may appeal to both conduitinvestors and the companies they help finance, but the risks are substantial, says OhioState's Sanders, and should be made transparent to the market. "The S&L crisis almostcrippled the economy wait until we have a banking crisis," he says.

Hopefully, more disclosure won't be the very thing that precipitates it.

Andrew Osterland is a senior editor atCFO.

In-securitization

Even a Triple-A-rated company like General Electric could be vulnerable if it wereunable to securitize assets easily. Through its finance subsidiary, GE currently usessponsored special-purpose entities (SPEs) and conduits to securitize its own and others'loans and receivables. The company's most recent annual report asserts that, if required(presumably in the event of an accounting change regarding the consolidation of SPEs),GE could use "alternative securitization techniques...at an insignificant incremental cost."Why not already do so? "It would still be an incremental cost," says CFO Keith Sherin.

"When you have the option, you go with the lowest cost."

Still, critics say that GE's statement in its annual report about SPEs is misleading,because such an accounting change would likely affect all off-balance-sheet financingalternatives. And if GE has to finance the assets on the balance sheet, the impact on itsfinancial statements will be more than incremental.A.O.

Paper Pushers


5/5

The 10 largest securitizers among financial service providers.Source: Standard & Poor's

Company Total

securitizations

including CP, in$millions

% of book

assets

CP conduits, in

$millions

Citigroup 129,452 12.1 51,441

ABN Amro Bank 92,304 17.8 46,955

J.P. Morgan Chase 80,652 10.1 42,350

Bank One 78,998 29.2 36,972

MBNA 73,534 170.6 0

Bank of America 43,066 6.7 18,301

Wachovia 39,757 12.2 4,278

Countrywide Credit 36,032 100.6 0

Deutsche Bank 33,041 6.4 5,245

Morgan Stanley Dean Witter 30,650 6.4 0

Documents

Financial Law Links