Must structured finance be obscure, or even misleading, to be effective? It certainly was misleading at Enron — and, until the transactions involved were made less obscure, quite effective. Citigroup and J.P. Morgan Chase & Co. lent more than $8 billion to Enron between 1992 and 2001, but set the financing up to look like a series of gas trades that could be recorded as revenue. So Enron's debt of $10 billion in 2000, for example, was understated by $4 billion, while its cash flow from operations of $3.2 billion was overstated by almost 50 percent — which kept its credit rating higher than it should have been, too.
The banks disavow any responsibility for the fact that these transactions ultimately helped bankrupt the energy company. But the only purpose of the deals was to mask debt as cash from trading operations. That wasn't immediately apparent in testimony before a Senate committee, where executives of both banks spent much of their time erecting a general defense of structured finance instead of explaining the objectives of their deals for Enron. "Structured financings have been used over the past several decades by virtually all sophisticated companies as a way of raising money," testified Rick Caplan, a Citigroup managing director.
Whether that way of raising money is legitimate is another question. For that to be so, the deals have to serve some purpose other than hiding the debt they create. That applies to all kinds of deals, not just those Enron employed. And the current backlash against such financing will make it incumbent upon corporate finance executives to make that purpose clear.
Those who use asset securitizations, synthetic leases, or other common structured financing techniques surely would prefer not to hear them equated with Enron's transactions. But the scandals have cast a pall over this entire sector of the capital markets, and are provoking major changes. For starters, the Financial Accounting Standards Board (FASB) plans to finalize tight new rules for special-purpose entities (SPEs) — the vehicles typically used to engineer the deals by taking the assets and debt involved off companies' balance sheets — by year's end. And the recently passed Sarbanes-Oxley Act of 2002 calls for a Securities and Exchange Commission study of off-balance-sheet disclosures in a year's time. Even the banks are deflecting the bad publicity by demanding specific public disclosures from their corporate clients. All this will make it much tougher to justify — or even find — structured finance deals.
The Chicken or the Egg?
Most such deals raise capital in spite of constraints posed by credit ratings or financial covenants. But it's impossible to separate structured finance from the accounting methods corporations use to achieve it. That raises the chicken-or-egg question underscored by recent scandals: Can the deal stand on its economic merits or does it depend on favorable accounting?
"The fundamental rationale for structured financing is the value it creates" by unlocking otherwise inaccessible capital, argues Andrew T. Feldstein, head of structured financing products at JPMorgan Chase. "The vast majority of structured finance transactions were done for good economic reasons. The anecdotes you hear about are the ones that were done badly."
But what is the economic purpose of structured finance deals that are done well — those, that is, that meet the rules for off-balance-sheet treatment? Some critics find little. Richard Thevenet, treasurer of MasterCard Inc., contends that accounting, not economics, all too often drives common structured finance transactions such as synthetic leases. That's apparent, says Thevenet, when one examines how they actually reduce a company's cost of capital. In fact, he contends that any such reduction is artificial. All things being equal, he says, "it's much cheaper to put [an asset] on the balance sheet," because "you're paying extra to have the appearance of it being off-balance-sheet." As for the cost savings, he adds, synthetic leases increase net income and operating cash flow because assets are depreciated for tax purposes, but not for accounting purposes. However, they lower total cash flow because the financing costs are so much higher. "So you've reduced cash flow and flexibility, increased costs, and for what reason? Window dressing, so you can move assets off reported books," says Thevenet.
No question, structured finance allows companies to obtain more capital than they would get as straightforward equity or debt. And even critics acknowledge that can sometimes be a good thing. "Structured finance allows people to raise money they may not otherwise be able to raise, and that access to capital contributes to productivity," says Lynn Turner, former chief accountant at the SEC and now an accounting professor at Colorado State University.
The problem is, investors need to know whether that capital can be profitably used. And they often can't when it's not on the balance sheet. Sure, proponents argue that proper deals meet accounting rules that require the terms to be disclosed in footnotes, but the fact is that such disclosures are sketchy at best. And unless the terms are sufficiently clear to be accounted for, the true cost and risk of such financing are not apparent.
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