VideoThe 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 times the audience it did last year. Such speakers as Treasury Secretary Paul O'Neill, Securities and Exchange Committee chairman Harvey Pitt, and capital-markets mainstay Paul Volcker undoubtedly helped the turnout, but a swarm of reporters also turned up to ask questions about special-purpose entities (SPEs) and other means of moving risk off corporate balance sheets. The media, of course, were looking for the next Enron.
"How do we help the market distinguish between what we do and what Enron did?" one association member asked Pitt. He had no ready answer. The off-balance-sheet genie is out of the bottle, and for the time being there's no easy way to put it back in. With the Financial Accounting Standards Board (FASB) currently deliberating on new rules for consolidating SPEs and disclosing off-balance-sheet activities, structured finance is in the spotlight. Even if regulators don't curb the activities, the hue and cry from investors is likely to keep it there.
The activities conducted through SPEs in the asset-backed securities market may indeed be a far cry from what Enron did, but they raise the same issues of disclosure and hidden risk. 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, the issue may extend beyond comparisons to Enron.
The subjects of greatest concern are the commercial banks. They use SPEs to securitize their own assets, and also sponsor asset-backed commercial-paper conduits, which purchase and securitize assets from third parties. New accounting rules for these activities will cost both banks and their corporate borrowers. "All the major banks sponsor CP conduits," says Jeff Allen, a senior manager with PricewaterhouseCoopers. "If they are forced to consolidate them, there are going to be a lot more assets on their balance sheets." And probably a need for more capital to meet regulatory reserve requirements. In that case, banks and near-banks may be compelled to rein in their SPEs and conduit programs, 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 by packaging them into securities — the most significant innovation in the capital markets in the past two decades. Since Fannie Mae and Freddie Mac got the ball rolling in the mortgage 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 and home-equity loans, commercial mortgages, and trade receivables. The practice allows originators 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 of credit to far more individuals and businesses in the United States. The bad thing about securitization 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 to nothing about the risks involved in the activities.
"The banks are a lot more leveraged than we think," says Ohio State University professor of finance Anthony Sanders. "If they fully disclosed their risks, some people would be telling them to pare back their exposure." Indeed, some people, notably Pacific Investment Management Co. (PIMCO) bond fund manager Bill Gross, are already doing so. 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 the company's heavy dependence on the short-term commercial paper market was becoming precarious. GE CFO Keith Sherin has indicated that the company will reduce the liquidity support it provides for its commercial-paper conduits, and the company has begun refinancing its debt structure in favor of longer maturities.
As the biggest players in the structured-finance market, commercial banks in the United States and Europe may have to do the same or more. A recent study of securitization programs 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 through commercial paper conduits. Conduit programs alone financed approximately $500 billion in assets last year — none of which appeared on corporate or bank balance sheets. Not much appeared in the footnotes, either. While Citigroup devoted some ink in its 2001 annual report to its securitizations of credit-card debt, it revealed next to nothing about the performance of $51 billion in assets residing in Citigroup-sponsored commercial paper conduits and other securitization structures.
While securitization has enabled banks to finance assets through the capital markets, the process hasn't eliminated the risks associated with those assets. In fact, in most cases, 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 are small, as was the case through most of the last decade. And to hear the banking community tell it, the asset pools serving as collateral for asset-backed bonds are still performing well. But no one knows for sure.
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