Through the Looking Glass

When is balance-sheet financing not balance-sheet financing? When it's done through a conduit.
Jasper MoiseiwitschMay 1, 2003

The conduit, that odd species of special purpose entity, is all the rage among the region’s universal banks. Citigroup, HSBC, Standard Chartered, ING, Bank of America and ABN AMRO make wide use of them for the simple reason that conduits allow them to exploit an equally peculiar regulatory loophole in their funding.

But to understand precisely why the likes of Citigroup, tarnished in scandals emerging from Enron’s misuse of special purpose entities, or SPEs, would be advocating the use of them in Asia takes some doing. Why? Because conduits involve a lot of fancy footwork to off-load risk. They allow banks to move loans off the balance sheet into a vehicle that transforms them into capital-generating assets. Since the SPEs remain in a banks’ possession and make money, they offset the cost of offering loans at below-market rates to cement banking relationships.

Somewhere in the process, the risk tied to the underlying asset simply vanishes – or so bankers say.

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Here’s how the money passes through the looking glass. Banks offload assets such as bonds, receivables, ABS programs, et cetera into the SPE. They then issue short-term commercial paper against these assets at very cheap rates, about seven to 10 basis points below Libor. The basic idea: banks fund their conduit programs with cheap commercial paper, and then on-lend this money into longer term and higher yielding investments. Conduits work because they match cheap short-term funding with these richer assets.

Green Cards

Banks can take advantage of this interest-rate arbitrage to lend at below market rates. A recent deal serves as an example. In February, Bank of America lead managed a five-year, US$300 million credit-card securitization for LG Card, and promptly put the deal into its Kittyhawk conduit.

David Ahn, LG Card’s manager of asset securitization team, said the deal carries a coupon of 45bp and that LG Card paid Bank of America a US$1 million arranger fee. The all-in payout of the deal comes to about 55bp, and Bank of America structured the transaction to an implied double-A rating. Assuming all these terms are accurate (bankers from rival institutions are skeptical) the deal is rock-bottom cheap.

By comparison, UBS and CSFB led a similar five-year securitization for LG Card in 2001. That triple A-rated deal was guaranteed by insurer FSA, and it carried a 55bp coupon. Counting the FSA costs and arranger fees, the deal paid an all-in of just over 100bp – almost twice as expensive as the Bank of America deal.

As a conduit transaction, the Bank of America deal is entirely private and it is hard to confirm all the details of the transaction. For example, there is talk that this deal carries a one-year early amortization trigger – effectively a one-year put for Bank of America, which would make it average priced (Ahn denies the deal comes with such a trigger).

Nevertheless, the deal’s conduit feature did make it cheaper than a normal capital markets’ transaction, much like the UBS/CSFB deal. “Because our conduits are funded from the US [short-term] commercial paper market at triple-A funding, that benefit is being passed along to the LG Card. That’s why we can be a little bit flexible on the pricing,” says Heesuk Noh, Bank of America’s vice president, asset securitization group, who was involved in the LG Card deal


Conduits make use of this interest-rate arbitrage but they also exploit a regulatory arbitrage. Banks have to allocate very little capital to their conduit programs compared to other forms of lending. The main commitment a bank makes to its conduit is its liquidity facility, which ensures that conduits remain fully funded even if the CP market dries up for whatever reason. If a conduit does not turn over its CP on a given month, the liquidity facility kicks in – and CP markets tend to dry up when they smell credit risk.

Current Basle regulations let banks apply a zero percent capital weighting to 364-day liquidity facilities, as this is considered short-term funding. But liquidity facilities are not short-term, and they don’t just guarantee against liquidity risk – they can also guarantee against long-term credit risk. Banks use liquidity facilities to maintain conduits that, for example, hold mortgage-backed assets that can go on for 25 years. And, over the long term, a lot might happen to such assets.

For example, ING reportedly lost US$500 million on one of its American conduit programs after triple- A rated nursing-home receivables went into default. Fraud was involved and the bank took the hit.

“Who actually ends up holding the asset if liquidity isn’t rock bottom? It’s usually the bank sponsor, the liquidity provider, which means they’ve actually got the credit risk,” says Anthony Cutcliffe, UBS’s head of structured debt products, Asia.

It’s an arbitrage effect. Banks can raise long-term funding through their conduit, but set zero capital against it. By comparison, the Hong Kong Monetary Authority requires an 8 percent capital adequacy ratio for its local banks; Singapore regulators require a 9 percent CAR.

Great for CFOs

The planners behind Basle II recognize that discrepancy and new rules should raise the capital reserve-requirements for liquidity facilities somewhere in line with current local lending reserve requirements. One-year facilities will need to set aside capital at the rate of 20 percent times the risk weight of the assets, or 4 percent for triple-A assets. Furthermore, new FASB guidelines, expected in July, should also increase the amount of on-balance sheet consolidation banks need to apply to their conduits.

For a variety of reasons, conduit programs generally belong to the universal banks. Investment banks, which tend to be more protective of their capital and which have less capital to put at risk, generally do not offer liquidity facilities even if they have a conduit program. But they get upset that regulators let the universal banks allocate zero capital for these facilities, which raises the banks’ returns on equity. “The investment banks are saying that’s a totally unfair advantage,” says Avinder Bindra, head of HSBC’s debt markets client group, Asia Pacific.

Structured finance bankers – whether they be at universal banking institutions or at investment houses – also acknowledge that conduits can be used by the universals as a form of relationship lending, to grow or maintain other client business. “There has been a lot of use of conduits by financial institutions to grow their agency business, mainly the banks, especially in Asia,” says a structured-finance specialist at an investment bank, who declined to be named.

Bank of America, for example, has an extensive relationship and extensive business – forex, trade finance, et cetera – with the LG Card parent, LG Group. “This is a first-time deal with LG Card, but LG Group and Bank of America have a long base of relationship,” says Bank of America’s Noh. “So this [the securitization deal] strengthens our relationship with LG Group.”

Conduit programs in this version may be a roundabout and oblique form of relationship lending. It takes the murkiness of relationship pricing and shakes them up in the black-box conduit structure. CFO get great pricing, banks get great returns on equity, and everyone’s happy barring a massive default within the program. “It’s great for CFOs,” Cutcliffe admits, “but bad for banks.”