VideoAccording to Mellon's Widich, the expected losses on its $1.2 billion in conduit assets were extremely difficult to calculate. "What's the expected loss when we've never come close to having a loss in 12 years?" he asks. "It's zero. Clearly zero wasn't going to cut it with the accountants."
And why should it, when past performance is no guarantee of future results? So Widich and his colleagues began studying FIN 46 and working the numbers. Looking at rating-agency data on the likelihood of downgrades and defaults, "we took a conservative approach and assumed anything that was downgraded defaulted," he says. Next, they figured in historic net losses in corporate defaults. Finally, they ran a Monte Carlo simulation of thousands of combinations of possible default frequency and net losses. At that point, says Widich, his team arrived at a number that satisfied Mellon's auditors that they had covered the expected loss. He won't disclose what that number is, except to say it's somewhere in single-digit basis points.
Next, Widich's team had to sell the subordinated note, which naturally meant paying a rate higher than that of the expected losses. He says demand was strong enough that Mellon was able to choose an investor that "knew the market and understood multiseller conduits and with whom we could partner."
Tallying the Cost
Despite Mellon's unwillingness to reveal the exact terms of its deal, it's easy enough to estimate the cost of a hypothetical transaction. If the rate of expected losses is 20 basis points and the return to investors in the note is 25 percent, the cost of participating in such a conduit would be an extra 5 basis points (25 percent of .0020). On a $100 million transaction, the additional cost of using such a conduit would be $50,000. Of course, that doesn't include the one-time costs of doing the actual restructuring, including lawyers and accounting fees.
Market participants differ on whether banks will decide to absorb these costs or pass them along to customers. (At press time, Mellon had not yet decided what to do.) Currently, the cost of participating in a traditional conduit ranges from 25 to 200 basis points, depending on a deal's liquidity and credit risk. A cost increase could hurt banks required to comply with U.S. accounting edicts, giving foreign banks a competitive advantage. Agreements for purchasing receivables for ABCP usually contain a provision that makes transference of cost increases automatic when the increase is due to an uncontrollable event. Some clauses specify that the pass-along is automatic when regulation increases regulatory capital, according to Sylvie Durham, chief investment officer at Abney & Holloway Asset Management in New York, which plans to invest in expected loss notes. But FASB is not a banking regulator, so simple consolidation may not trigger the clause, she says.
Still, most experts predict that the costs will be passed along. "It is a legitimate cost that should be borne by the users of the conduits," says the head of ABCP origination at one major investment bank.
Will customers accept such a cost increase? Bankers think so, if only because many of their ABCP clients are loan clients as well. "Marginally increased costs won't cause them to pull out," Durham says. At least one corporate finance executive agrees. Although "we never like costs to go up," says General Motors's assistant treasurer, Sanjiv Khattri, the company recently used a restructured conduit that is "slightly more expensive" to refinance the office space it leases in Detroit's Renaissance Center.
But some observers point out that returns on the subordinated notes, and thus costs of conduits restructured through their use, will have to exceed 25 percent if expected losses exceed 20 percent, which is likely for assets whose credit quality is less than stellar.
"I'd be willing to bet that those now paying 200 basis points to participate in a conduit will pay a lot more," says Jeff Wallace, a principal in Greenwich Treasury Advisors, in Greenwich, Connecticut.
The question of whether conduits will remain worthwhile may come down to whether they will continue to be less expensive than such alternatives as revolving credit. That depends on whether the banks also boost their pricing on revolvers and the like to maintain the current cost advantage of conduits. The answer to that question at this point is unclear.
Hilary Rosenberg is a kindergarten teacher and writes on finance from New York.
One out of Three Ain't Bad
Banks have examined three different means of restructuring their conduits:
The Silo Method. Bank of America reportedly used this technique to restructure about $6 billion of its roughly $22 billion in conduit assets. In this arrangement, companies that have sold assets into the pool consolidate the assets and liabilities on their own books, with each set of assets being a "silo." Such an arrangement isn't really asset-backed lending, but more of a traditionally collateralized loan. And the participants in the new entity already consolidated the assets and liabilities. This technique will not become more common unless other companies are willing to do the same, and so far there's little sign of that.
Joint Venture. A few banks reportedly are attempting to form a joint venture for purposes of restructuring their conduits, although they hadn't completed the transaction at press time. The concept: If three or more conduit sponsors combine their conduits, no one of them could be the primary beneficiary—and thus all would escape the confines of FIN 46. Each sponsor would provide liquidity and credit enhancement, and the commercial paper would be backed by all of the conduit assets. The trouble with this approach, besides its complexity, is that "you are exposed to the credit risk of a competitor's clients and the underwriting of a competitive sponsor," says Deborah Seife, managing director at Fitch Ratings.
Reader Comments» Post a comment