The structured-finance geeks on Wall Street used to ply their trade in relative obscurity. Not anymore.
The annual Bond Market Association meeting in New York on April 25 drew four times the audience it did last year. Such speakers as Treasury Secretary Paul O'Neill, Securities and Exchange Committee chairman Harvey Pitt, and capital-markets mainstay Paul Volcker undoubtedly helped the turnout, but a swarm of reporters also turned up to ask questions about special-purpose entities (SPEs) and other means of moving risk off corporate balance sheets. The media, of course, were looking for the next Enron.
"How do we help the market distinguish between what we do and what Enron did?" one association member asked Pitt. He had no ready answer. The off-balance-sheet genie is out of the bottle, and for the time being there's no easy way to put it back in. With the Financial Accounting Standards Board (FASB) currently deliberating on new rules for consolidating SPEs and disclosing off-balance-sheet activities, structured finance is in the spotlight. Even if regulators don't curb the activities, the hue and cry from investors is likely to keep it there.
The activities conducted through SPEs in the asset-backed securities market may indeed be a far cry from what Enron did, but they raise the same issues of disclosure and hidden risk. And given that more than a trillion dollars of assets were taken off corporate balance sheets last year and put into SPEs and vehicles known as commercial-paper conduits, the issue may extend beyond comparisons to Enron.
The subjects of greatest concern are the commercial banks. They use SPEs to securitize their own assets, and also sponsor asset-backed commercial-paper conduits, which purchase and securitize assets from third parties. New accounting rules for these activities will cost both banks and their corporate borrowers. "All the major banks sponsor CP conduits," says Jeff Allen, a senior manager with PricewaterhouseCoopers. "If they are forced to consolidate them, there are going to be a lot more assets on their balance sheets." And probably a need for more capital to meet regulatory reserve requirements. In that case, banks and near-banks may be compelled to rein in their SPEs and conduit programs, and the terms for both loans and asset-backed commercial paper would tighten. Moreover, without the liquidity guarantees provided in bank-sponsored conduits, many companies might lose their access to the asset-backed market altogether. Can you say "credit crunch"?
At stake for the business community is the ability to make illiquid assets liquid by packaging them into securities — the most significant innovation in the capital markets in the past two decades. Since Fannie Mae and Freddie Mac got the ball rolling in the mortgage market as part of their mandate to foster home ownership in America, securitization has expanded into a variety of markets, including credit-card debt, auto and home-equity loans, commercial mortgages, and trade receivables. The practice allows originators to sell assets from their balance sheets and devote their capital to generating new business. The good thing about securitization is that it has enabled the extension of credit to far more individuals and businesses in the United States. The bad thing about securitization is that financial-reporting practices haven't kept up with the innovation. Because the programs are executed in SPEs off-balance-sheet, investors know next to nothing about the risks involved in the activities.
"The banks are a lot more leveraged than we think," says Ohio State University professor of finance Anthony Sanders. "If they fully disclosed their risks, some people would be telling them to pare back their exposure." Indeed, some people, notably Pacific Investment Management Co. (PIMCO) bond fund manager Bill Gross, are already doing so. The heaviest hitter in the bond market recently accused General Electric of using off-balance-sheet activities to manipulate its reported earnings, and also suggested that the company's heavy dependence on the short-term commercial paper market was becoming precarious. GE CFO Keith Sherin has indicated that the company will reduce the liquidity support it provides for its commercial-paper conduits, and the company has begun refinancing its debt structure in favor of longer maturities.
As the biggest players in the structured-finance market, commercial banks in the United States and Europe may have to do the same or more. A recent study of securitization programs by Standard & Poor's showed that all the major banks, and many minor ones, conduct significant off-balance-sheet securitizations through their own SPEs and through commercial paper conduits. Conduit programs alone financed approximately $500 billion in assets last year — none of which appeared on corporate or bank balance sheets. Not much appeared in the footnotes, either. While Citigroup devoted some ink in its 2001 annual report to its securitizations of credit-card debt, it revealed next to nothing about the performance of $51 billion in assets residing in Citigroup-sponsored commercial paper conduits and other securitization structures.
While securitization has enabled banks to finance assets through the capital markets, the process hasn't eliminated the risks associated with those assets. In fact, in most cases, banks and asset-sellers have retained the majority of the risk of assets transferred off-balance-sheet. The process works fine when the economy is strong and credit losses are small, as was the case through most of the last decade. And to hear the banking community tell it, the asset pools serving as collateral for asset-backed bonds are still performing well. But no one knows for sure.
"We're comforted somewhat by the fact that regulators are looking at these things closely," says S&P bank-rating analyst Tanya Azarchs. Indeed, in January, the SEC and the Federal Reserve Board forced PNC Bank to consolidate distressed loans it had transferred into three SPEs. The result was a $155 million hit to PNC's first-quarter earnings.
FASB is determined that investors should be looking at these things more closely as well. Under current rules regarding SPE accounting, neither financial-services firms nor other types of businesses need disclose much about their off-balance-sheet activities. Even the rating agencies have to essentially take banks at their word about the performance of the assets in their SPEs and conduits. If the economy's uncertain recovery falters, or a September 11like event shocks the market again, the portfolios are almost certain to deteriorate. Now, says Sanders, is the time to be providing details about risk exposures and potential liabilities. "I shudder to think of the litigation they may face if they don't start disclosing things now," he says. "If they keep this game going, there could be a massive Wall Street panic down the road."
Alarmist? Perhaps, but Sanders has a point. No matter how finance engineers slice and dice it, risk cannot be extinguished, it can only be transferred or redistributed. In the asset securitization process, companies create a hierarchy of different securities — or tranches — with varying degrees of credit risk associated with a pool of assets. The tranches produced in a typical asset-backed deal range from AAA credits down to BB.
The investor community certainly loves the practice. With the federal government issuing less debt, and only a handful of corporations still holding a AAA credit rating, highly rated, asset-backed paper is an easy sell with institutional investors. That's why securitization can lower the cost of capital for companies, say proponents.
But in most cases, the originator of the asset — whether it is a manufacturing company financing trade receivables or a specialty finance lender securitizing loans — retains a residual interest in the performance of the assets. This interest obligates the issuer to cover losses in the asset pool up to a certain percentage. If losses exceed that percentage, other low-rated, subordinate tranches of the issuance begin to absorb them. "The post-Enron fear is that there's all sorts of stuff out there we didn't know existed," says Azarchs. "Now you wonder about what you don't know." Not exactly a confidence booster for investors. The billion-dollar question is, who holds those subordinate tranches?
With riskier slices of asset-backed securitizations harder to sell these days, the answer is, fewer and fewer investors. In many cases, collateralized debt and bond obligation (CDO and CBO) vehicles, many of them sponsored by European banks such as ABN Amro and Deutsche Bank, buy the lower tranches. CDOs and the like control about $400 billion in assets. Again, however, no one knows for sure. "It's all innuendo and rumor," says Azarchs. A particularly troubling possibility is that the banks are scratching one another's backs. "It may be that a given financial institution has held not its own subordinate tranches, but similar ones in deals sponsored by others," wrote Azarchs in a recent report.
The risks for banks don't end there. The banks also agree to provide liquidity support if cash flow from the conduit isn't enough to pay off the paper as it matures. If enough loans in a conduit go bad, the sponsor bank could be liable. That may appeal to both conduit investors and the companies they help finance, but the risks are substantial, says Ohio State's Sanders, and should be made transparent to the market. "The S&L crisis almost crippled the economy — wait until we have a banking crisis," he says.
Hopefully, more disclosure won't be the very thing that precipitates it.
Andrew Osterland is a senior editor at CFO.
Even a Triple-A-rated company like General Electric could be vulnerable if it were unable to securitize assets easily. Through its finance subsidiary, GE currently uses sponsored special-purpose entities (SPEs) and conduits to securitize its own and others' loans and receivables. The company's most recent annual report asserts that, if required (presumably in the event of an accounting change regarding the consolidation of SPEs), GE could use "alternative securitization techniques...at an insignificant incremental cost." Why not already do so? "It would still be an incremental cost," says CFO Keith Sherin. "When you have the option, you go with the lowest cost."
Still, critics say that GE's statement in its annual report about SPEs is misleading, because such an accounting change would likely affect all off-balance-sheet financing alternatives. And if GE has to finance the assets on the balance sheet, the impact on its financial statements will be more than incremental. —A.O.
The 10 largest securitizers among financial service providers.
Source: Standard & Poor's
|Company||Total securitizations including CP, in $millions||% of book assets||CP conduits, in $millions|
|ABN Amro Bank||92,304||17.8||46,955|
|J.P. Morgan Chase||80,652||10.1||42,350|
|Bank of America||43,066||6.7||18,301|
|Morgan Stanley Dean Witter||30,650||6.4||0|