Capital Markets

Anxiety’s Price

New regulations call into question the value of off-balance-sheet financing -- if only because of their impact on bankers' fees.
Randy MyersMarch 1, 2003

The Financial Accounting Standards Board’s new rules for off-balance-sheet financing may not prevent another Enron, but they could very well increase the cost of capital for more honest companies.

For one thing, companies that have to consolidate off-balance-sheet entities will report higher leverage than before, which, all things being equal, may increase the cost of new public-debt offerings for them. Other companies, forced to greater lengths to keep their entities off the books, could find such financing more expensive because of the extra legal and banking work involved.

Cost is clearly an issue for finance executives. MBNA America Bank issues asset-backed securities through such arrangements, says Vernon Wright, executive vice chairman and chief corporate finance officer, “because securitizations serve as a stable, long-term source of cost-effective funding.” The new accounting rules, coupled with closer scrutiny, raise doubts that such financing will continue to serve as such.

Some observers contend that the increased cost will be offset by the resulting gain in investor confidence. “Further negative surprises are not something we want right now,” says Anthony Sanders, an Ohio State University finance professor and an adamant proponent of consolidation. “We need to have confidence in the marketplace, and I think the general principle of having people consolidate and declare what risk exposure they have is incredibly valuable to the economy.”

In essence, the rules FASB issued in January say assets held by special-purpose entities (SPEs) — or what FASB is calling variable-interest entities (VIEs) — must be put back on a sponsor’s own books if it retains a controlling financial interest in them. But even if a sponsor doesn’t have to consolidate the VIEs, it has something to worry about, because the banks that arrange them may have to do so or go to considerable lengths not to. Either possibility will mean at least some extra cost for the companies that are their customers.

Extra Players

In fact, U.S. banks that operate huge asset-backed securitization conduits, through which they issue asset-backed commercial paper for multiple corporate clients, are most likely to be affected by the consolidation requirement. These banks typically provide both liquidity and credit enhancements to deals executed through their conduits. According to a report by Standard & Poor’s credit analyst Tanya Azarchs, this could, under a rule known as Interpretation No. 46 (FIN 46), require the conduit sponsors to bring the assets and liabilities involved onto their balance sheets.

It’s possible, to be sure, that banks could restructure their conduits to qualify for nonconsolidation under the new rules, but at this point most structured-finance experts are uncertain how exactly that might be done. The new rules do not apply to VIEs considered to be “qualifying” SPEs (QSPEs) under FAS 140, which generally include most SPEs created to facilitate issuance of asset-backed securities other than asset-backed commercial paper or collateralized debt obligations (CDOs) — essentially, bonds backed by other bonds. But those are precisely the types of securities that many corporate borrowers have come to depend on.

What’s more, in late January FASB announced it was undertaking a project to issue a limited-scope interpretation of FAS 140, which accountants say could limit the ability of QSPEs to retain that status.

Traditionally, banks have assured the liquidity of their asset-backed commercial paper deals by agreeing to buy assets out of the conduit, if necessary, to ensure payment to investors. This possibility might arise if there were a complete disruption of the commercial paper market or if the asset performance of a particular deal started to deteriorate. Another route to assuring liquidity is through credit enhancement, accomplished a number of ways. The most common is through overcollateralization of the deal by the seller securitizing assets, but it can also be done though the issuance of a subordinated loan from the bank or the purchase of a surety bond from a monoline insurance company.

To qualify for nonconsolidation under the new rules, Jason Kravitt, New York-based senior partner in the law firm Mayer, Brown, Rowe & Maw, says banks may share credit enhancement and liquidity with third parties. “Instead of the sponsor providing the overwhelming amount of liquidity and credit enhancement,” he says, “I expect it to bring in third parties to do that.” Of course, bringing in another party adds to any deal’s price tag.

Indeed, J.P. Morgan Chase’s recent agreement to pay some $400 million to settle a dispute with 11 insurers over surety bonds it provided for an Enron SPE shows just why credit enhancement could become much more expensive. The settlement wiped out a third of Morgan’s earnings for the quarter.

Bigger Fees

FIN 46 also may require U.S. collateral managers, some of which may be banks, to consolidate some portion of the CDOs they have arranged, unless, of course, they are able to restructure them too. CDOs are sold in various tranches with varying degrees of risk and yield. Collateral managers manage those underlying assets, which are often bonds issued by companies with below-investment-grade credit ratings. Recasting these deals to avoid consolidation, Kravitt says, may require renegotiating the fee paid to the collateral manager, increasing the equity portion of the deal, or qualifying for other exemptions. Again, however, each of those solutions could mean additional cost that would be passed along to the bonds’ issuers.

One financial strategy that promises to become prohibitively costly for most companies involves synthetic leases, which are typically used to take such assets as real estate off corporate balance sheets. These deals almost always use SPEs that wouldn’t qualify for nonconsolidation under FIN 46. “Instead of being done out of SPEs, they will have to be done out of substantive operating entities,” says Kravitt, “which may reduce the volume of these transactions.” Some companies, including Cisco Systems Inc., Silicon Graphics Inc., and Krispy Kreme Doughnuts Inc., have already ended their synthetic-lease programs.

In addition to specifying when VIEs must be consolidated, FIN 46 adds disclosure requirements for certain VIEs that don’t need to be consolidated. FIN 46 applies immediately to VIEs created after January 31 of this year; it applies in the fiscal year or interim period beginning after June 15, 2003, to VIEs started or acquired before February 1, 2003.

FASB is not the only organization requiring greater disclosure relating to SPEs. On January 22, the Securities and Exchange Commission implemented portions of the Sarbanes-Oxley Act of 2002 by requiring, among other things, that companies begin disclosing in their annual and quarterly SEC filings all material off-balance-sheet transactions and obligations with unconsolidated entities. (To read more about those new regulations, click here.)

Despite the added regulatory burden, George Miller, deputy general counsel for the Bond Market Association, predicts that the growth of structured finance will not be interrupted. “The world of securitization — the vast majority of that market, which has now grown to be quite significant in terms of its overall size and scope and importance — is going to continue in a very robust way, just as it has up until this time,” he says.

Maybe. But consolidation and additional disclosure required by the regulators, in light of the increasing incidence of corporate bankruptcies, will inevitably raise questions about the legitimacy of many deals.

More Capital

The viability of deals that do pass muster will depend on just how much more expensive they become. Maureen Coen, managing director and head of asset-backed commercial-paper origination for Credit Suisse First Boston in New York, says that until now, conduit transactions have been priced to account for three costs: credit risk (the chance that the assets underlying the deal — that is, credit-card receivables — won’t perform), liquidity risk (the risk that the bank sponsor or some other third-party entity may have to buy assets out of the conduit to ensure payment to investors in the deal), and administrative costs. Together, those three costs can vary tremendously from deal to deal, ranging from as little as 25 basis points to perhaps 200, depending primarily on the deal’s credit and liquidity risk.

If banks are forced to bring conduit assets onto their books, Coen says, they will have to factor a fourth cost component into their deals: that of the additional regulatory capital they would have to hold against those formerly off-balance-sheet assets. Currently, they hold only a minimal amount against their conduits, she says.

S&P’s Azarchs says the rating agency doesn’t expect that any bank would fall out of compliance with the regulatory minimums on those ratios or suffer a ratings downgrade from S&P as a result, in part because the risk the banks bear with these structures is “generally not very high.”

But the cost of noncompliance would be considerable. The regulatory minimum amount of capital that must be held against on-the-books assets is 8 percent. “And capital is fairly expensive,” notes Coen. “So on first-blush analysis, it appears there would have to be a substantial increase in the cost of these conduits.” While reluctant to estimate how great those cost increases might be, she admits, “It’s going to be expensive. It’s not going to be a de minimus amount.”

While Coen says she’s optimistic that conduit assets can be kept off bank balance sheets, she admits that doing that also may involve “slightly” higher costs. “For instance,” she says, “one way of maintaining these vehicles off-balance-sheet is to go out and actually sell equity in the conduit. Equity holders may demand a higher return, and that would add some additional costs.”

Alternatively, she says, the conduit sponsor could sell subordinated debt rather than equity. But transferring risk associated with the conduit in either manner involves extra expense.

Before an equity sale would make sense, Coen cautions, the asset-backed commercial paper market must figure out how much equity would have to be sold to allow a conduit to remain off the sponsor’s balance sheet. FIN 46 says any entity holding exposure to more than 50 percent of the conduit’s expected losses would have to consolidate its assets on its books. “There’s some ambiguity as to what is meant by expected losses,” explains Coen. “Under what we think FASB means, most conduits would have to be consolidated on their sponsor’s books.”

Thus far, says Coen, competitive pressure has prevented banks from factoring these potentially higher costs into their asset-backed commercial paper deals, but she says there has been a slowdown in conduit activity as some corporations and bank sponsors await a consensus on how to deal with FASB’s new rules.

Once consensus emerges, however, corporate customers can look for higher price tags. To be sure, the cost of commercial paper conduits should still be lower than other types of short-term debt.

“Over the last three years, the cost of bank revolvers and other liquidity facilities has been trending up, due to consolidation in the banking industry and rational pricing,” says Joe Donovan, managing director and head of asset finance at Credit Suisse First Boston. “The world is moving from unsecured lending to secured lending, and nobody wants this to become exorbitantly expensive. But the name of the game for everybody in any industry is return on capital, and if banks are forced to put more capital into these structures, they’re going to have to extract a higher price. It’s just math.”

Sidebar: Whose Assets?

Critics of securitization contend that most sponsors retain credit risk in such arrangements, because they don’t transfer the benefits and burdens of ownership of the underlying assets to investors. Only when that happens is there a true sale of the assets rather than a secured loan.

While more-obvious differences between legitimate deals and sham transactions were made clear by Enron’s meltdown, The LTV Corp.’s insolvency does more to clarify this finer but no less fundamental distinction. And with corporate bankruptcies showing no sign of letting up, that distinction promises to become increasingly critical.

During the Ohio steelmaker’s bankruptcy hearings in March 2001, the judge in the case opined that the investors in a securitization arranged for LTV through Mellon Bank had no right to the assets involved, because the deal amounted to a loan, not a sale.

“The argument there was that the seller was retaining too much burden on the asset,” observes New York-based Ren Martin, a partner in the law firm Sidley Austin Brown & Wood. But, says Martin, “nobody wanted to bite the bullet and get a full court decision,” so the parties settled. In order to gain control over the asset, Mellon agreed to provide LTV with debtor-in-possession financing, as secured lenders often do in a bankruptcy to improve their chances of recovering collateral.

A few more such cases and the notion that assets automatically become “bankruptcy remote” when securitized may be shown to be mythical — even in the absence of Enron-like fraud.