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Commercial Paper Chase

If banks have to come clean about their off-balance-sheet leverage, get


ready to pay more for money.

Andrew Osterland - CFO Magazine

June 1, 2002

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.

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• Pensions as Earnings Drag?
• S&P Unveils New Earnings Gauge
• Reining In SPEs

"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"?

Know-Nothings
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.

Commercial Paper Chase


(continued)

"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."

Immortal Risk
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.

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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.

In-securitization

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.

Paper Pushers
The 10 largest securitizers among financial service providers.
Source: Standard & Poor's

Company Total % of book CP conduits, in


securitizations assets $millions
including CP, in
$millions
Citigroup 129,452 12.1 51,441
ABN Amro Bank 92,304 17.8 46,955
J.P. Morgan Chase 80,652 10.1 42,350
Bank One 78,998 29.2 36,972
MBNA 73,534 170.6 0
Bank of America 43,066 6.7 18,301
Wachovia 39,757 12.2 4,278
Countrywide Credit 36,032 100.6 0
Deutsche Bank 33,041 6.4 5,245
Morgan Stanley Dean Witter 30,650 6.4 0

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