VideoExpected-Loss Tranche. By far the most popular method for restructuring ABCP conduits, this carries the greatest ongoing cost to corporate customers. The concept here is that a third-party investor in the conduit covers the majority of the expected losses (before the bank's credit enhancement), which by FIN 46's definition makes it, not the bank, the primary beneficiary. The bank has to estimate the expected losses from the pool, construct a subordinated note worth more than that amount (leaving room for the conduit to grow), and pay an interest rate high enough to sell that note to an investor willing to consolidate the conduit's assets and liabilities on its own balance sheet. Critically, the bank's credit enhancement does not make it the primary beneficiary under FIN 46. —H.R.
Conduits to Hell?
Critics contend that banks's increasing use of asset-backed commercial paper (ABCP) conduits threatens the health of the global financial system, because they make it harder to keep tabs on bad debt. Proponents suggest the opposite is true, because the off-balance-sheet financing technique serves to spread the risk of credit losses to outside investors. But the fact is, those investors understand credit risk less thoroughly than banks do. And a proposed change in bank regulations may inadvertently encourage riskier credits to be transferred.
Under rules that went into effect in 1988, the capital required to support a high-grade, AAA loan is the same as that required for a single-B loan. Because more-creditworthy loans carry lower interest rates, superior assets are more expensive for a bank to keep on its balance sheet than lower-quality assets, so better assets have more frequently been taken off bank balance sheets through ABCP conduits.
Indeed, these rules drove the banks into the business in the first place. Lenders quickly found it profitable to use high-quality corporate assets such as trade receivables to support the issuance of commercial paper by creating an entity outside the bank to contain the operation while collecting fees from corporate participants. The banks' only risk would be in providing credit enhancement and liquidity.
"It was regulatory arbitrage," says one investment banker who asked to remain anonymous. "On the balance sheet, capital would be required [to be set aside] on 100 percent of the assets. When assets were kept outside the bank, the bank was charged capital only as it interfaced with the conduit in providing credit enhancement. The point was they were saving regulatory capital."
Today, the ABCP market is a $734 billion business involving thousands of corporations and most of the major banks, according to David Zion, a banking analyst for Credit Suisse First Boston. Starting in 2007, however, banks will have to adjust their capital reserves to reflect the risk of losses on their loans, so lower-quality assets will require more support than higher-quality ones. That will create an incentive for banks to move poorer-quality assets as well as higher-grade ones off their books through ABCP conduits. And risk transfer of this kind has some regulators worried. "The transferors may have proper insight into the nature of the risks," Andrew Large, deputy governor of the Bank of England, was recently quoted in the Economist magazine (CFO's sister publication) as saying, but "are the transferees actually aware of the risks they have taken on?"
To be sure, new rules from the Financial Accounting Standards Board may inhibit banks' ability to put lower-rated assets into conduits, because the rules encourage banks to turn to third-party investors willing to put the assets on their own balance sheets. Experts say investors therefore could become warier of risky assets. Of course, that assumes that the investors have an adequate understanding of credit quality. But greater vigilance on their part would suggest that FASB has done more to protect the financial system than have banking regulators. —Ronald Fink
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