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Anxiety's price: new regulations call into question the value of off-balance-sheet financing, if only because of their impact on bankers' fees - Special Report Banking

CFO: Magazine for Senior Financial Executives, March, 2003 by Randy Myers

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.

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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 (see "Reining in SPEs," CFO, May 2002). 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 over-collateralization 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 (see 'The Uncertainty of Surety," September 2002). 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.

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Anxiety's price: new regulations call into question the value of off-balance-sheet financing, if only because of their impact on bankers' fees - Special Report Banking

CFO: Magazine for Senior Financial Executives, March, 2003 by Randy Myers

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