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

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 other types of businesses need disclose much about their off-balance-sheet activities. Even the rating agencies have to essentially take banks at their word about the performance of the assets in their SPEs and conduits. If the economy's uncertain recovery falters, or a September 11­like event shocks the market again, the portfolios are almost certain to deteriorate. Now, says Sanders, is the time to be providing details about risk exposures and potential liabilities. "I shudder to think of the litigation they may face if they don't start disclosing things now," he says. "If they keep this game going, there could be a massive Wall Street panic down the road."

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

The investor community certainly loves the practice. With the federal government issuing less debt, and only a handful of corporations still holding a AAA credit rating, highly rated, asset-backed paper is an easy sell with institutional investors. That's why securitization can lower the cost of capital for companies, say proponents.

But in most cases, the originator of the asset — whether it is a manufacturing company financing trade receivables or a specialty finance lender securitizing loans — retains a residual interest in the performance of the assets. This interest obligates the issuer to cover 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 for investors. 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 (CDO and CBO) vehicles, many of them sponsored by European banks such as ABN Amro and Deutsche Bank, buy the lower tranches. CDOs and the like control about $400 billion in assets. Again, however, no one knows for sure. "It's all innuendo and rumor," says Azarchs. A particularly troubling possibility is that the banks are scratching one another's backs. "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 if cash flow from the conduit isn't enough to pay off the paper as it matures. If enough loans in a conduit go bad, the sponsor bank could be liable. That may appeal to both conduit investors and the companies they help finance, but the risks are substantial, says Ohio State's Sanders, and should be made transparent to the market. "The S&L crisis almost crippled 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 at CFO.

In-securitization

Even a Triple-A-rated company like General Electric could be vulnerable if it were unable to securitize assets easily. Through its finance subsidiary, GE currently uses sponsored 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 financing alternatives. And if GE has to finance the assets on the balance sheet, the impact on its financial statements will be more than incremental. —A.O.

Paper Pushers

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

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