Longer paper routes: banks have gone to greater lengths to keep assets off their balance sheets. That means higher prices for commercial paper

CFO: Magazine for Senior Financial Executives,  Oct, 2003  by Hilary Rosenberg

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According 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.