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4 PATHOLOGY OF DEBT PART 5: Off-balance-sheet
debt By Henry C K Liu
June
30, 2007, there were over 200 such conduits
worldwide, with approximately $900 billion of ABCP
outstanding, comprising two-thirds of the
outstanding ABCP rated by Moody’s. On June 30,
2000, ABCP outstanding was $570 billion. By the
end of year 2001, it had reached $745 billion, up
from $641 billion at year-end 2000.
Unlike
the bank-sponsored conduits in the US and Europe, the
bank-sponsored ABCP market in
Japan had been reported by Moody's as largely
unaffected by the recent market turmoil. But the
Tokyo stock market suffered its sixth straight
loss on Friday, November 9, amid persisting
nervousness about the impact of the subprime
mortgage crisis. Selling accelerated late in the
day on November 9 following a news report that
Mizuho Securities might have lost as much as 100
billion yen (US$8.7 billion) due to the turmoil
stemming from problems in the subprime mortgage
market. Moody’s also rates 20 bank-sponsored ABCP
conduits in Australia and Asia with $39 billion
outstanding.
Some of the notable
administrators of ABCP in the US market are:
Citigroup NA, ABN-AMRO Bank NV, Banc One NA, JP
Morgan Chase; General Electric Capital;
Westdeutsche Landesbank Girozentrale; Rabobank
Nederland; Liberty Hampshire Co LLC; Societe
Generale; Bank of America National Trust &
Savings Association; Canadian Imperial Bank of
Commerce; Barclay's Bank PLC; Credit Suisse First
Boston; First Union National Bank, Charlotte;
Bayerische Landesbank Girozentrale; General Motors
Acceptance Corporation; Firstar Bank NA and
Dresdner Bank AG.
Back in an unusually
heavily attended 2002 annual Bond Market
Association meeting in New York featuring then
treasury secretary Paul O'Neill, Securities and
Exchange Committee chairman Harvey Pitt, and
former Fed chairman Paul Volcker, a swarm of
reporters, looking for the next Enron, turned up
to ask questions about special-purpose entities
(SPEs) and other means of moving risk off
corporate balance sheets. One association member
asked Pitt how the market could distinguish
between how SPEs now were different from those
used by Enron, which had been deemed legally
fraudulent. Pitt had no ready answer. The
off-balance-sheet genie had been let out of the
bottle, and there was no easy way to put it back
in.
New accounting rules The
Financial Accounting Standards Board (FASB)
adopted new rules for consolidating SPEs and
disclosing off-balance-sheet activities. SPEs can
no longer be all-purpose entities, especially not
the kind of debt-hiding entities that Enron used
and abused to puff up its profits. Interpretation
No. 46, "Consolidation of Variable Interest
Entities", expands on existing rules to more
precisely specify under what conditions a parent
company must consolidate an off-balance-sheet SPE.
Now, the question of consolidation is a matter of
who takes the risks and who reaps the rewards of
the enterprise.
Hundreds of US companies
keep trillions of dollars in debt in
off-balance-sheet subsidiaries and partnerships,
skirting the consolidation rules of FASB 94, FASB
125 and FASB 140. If a company creates an SPE, a
legal structure, with a 3% minimal equity
infusion, is does not have to consolidate the
transaction under SEC and FASB rules. Banks
arrange many of the devices and are big users
themselves. JP Morgan revealed in the Enron
bankruptcy that it had nearly $1 billion in
potential liabilities stemming from a single
49%-owned Channel Islands entity called Mahonia
that traded with Enron. Dell Computer had a joint
venture with Tyco called Dell Financial Services
(DFS) that originated $2.5 billion in customer
financing, mentioned only as a footnote to Dell's
accounts. Dell owned 70% of DFS, but did not
control it and therefore could keep DFS debts off
its own balance sheet.
To move assets off
its books, a company typically sells them to an
SPE, funding the purchase by borrowing cash from
institutional investors. As a sweetener to protect
investors, many SPEs incorporate triggers that
require the parent to repay loans or give them new
securities if its stock falls below a certain
price or credit-rating agencies downgrade its debt
or other triggering events. However, the
International Accounting Standards Board (IASB)
resisted this type of treatment. Under pending
European Union legislation, all listed companies
in the EU had to report under IASB by 2005, except
those that report under US GAAP, which would have
to move to IASB by 2007.
Moving debt off
the balance sheet is more difficult in Europe than
in the US under IASB rules, which use the standard
of whether a company participates in the risks and
rewards attached to that debt in deciding whether
debt can be off-balance-sheet. By contrast, US
GAAP uses the standard of what legal form such an
entity takes. In the post-Enron world, the rules
on off-balance-sheet debt have tightened up, but
new loopholes have been exploited. Under existing
accounting rules, the assets of SPEs must be
consolidated when outside investors' stakes are
protected in that fashion. Yet some 42% of
off-balance-sheet debt provides guarantees for
outside investors in indirect ways to get around
the rules.
Synthetic
leases Synthetic leases allow a company to
own financial instruments that would give it the
tax benefits of ownership without the accounting
burdens of ownership. Synthetic leases are
designed under current accounting rules to achieve
off-balance sheet treatment of both assets and
liabilities by classifying lease payments as
operating expenses. Return on assets (ROA), return
on equity (ROE), interest-coverage ratios and
leveraging ratios (debt to equity) are improved
relative to standard on-balance sheet treatment.
Synthetic transactions qualify for
off-balance sheet status if the lease does not:
(1) transfer ownership of the property at the end
of the lease term; (2) does not contain an option
to purchase at a bargain price; (3) the
non-cancelable lease term is not equal to or
greater than 75% of the estimated economic life of
the property; and (4) the present value of rents
and other minimum lease payments does not equal or
exceed 90% of the fair market value of the
property.
Generally, the ownership
transfer and bargain purchase criteria are
structured to provide a fixed, market-rate
purchase price at the end of the lease term. The
non-cancelable lease term is structured so that
the non-cancelable portion of the lease term is
short-term.
Under a synthetic lease, the
lessee retains the tax advantages of ownership
since the transaction places significant benefits,
burdens and control of ownership with the
corporate user, who is regarded as the tax owner
of the property and is eligible for the
accelerated depreciation and interest deductions
contained in the lease payments.
Several
factors determine if synthetic leases are
beneficial to a company: (1) the value of the
asset is expected to appreciate over time; (2) the
cash tied up in the asset can be better utilized
and (3) 100% financing allows the company faster
more cost-effective growth. In most cases, 100%
financing is available, thus creating a structure
with an ''all in'' cost that may be substantially
lower than traditional financing programs.
Synthetic leases are used for financing
equipment integrated into industrial buildings,
corporate headquarters, hospitals, single-tenant
offices, movie theaters, hotels, retail branches,
call centers and data centers. Under a synthetic
transaction, a capital source provides funding for
the construction or acquisition of equipment to be
utilized by and leased to a corporate user. If the
equipment is purchased by the user upon the
expiration of the lease, a predetermined purchase
price is paid to the lessor. Funding sources for
synthetic leases are commercial paper on a
floating-rate or fixed-rate basis through
interest-rate swaps, private placement, bank debt
or other sources.
Leases can be structured
such that funds are provided on a drawn basis
usually with spreads over bankers’ acceptances, or
an undrawn basis where funds are raised in the
commercial paper market by a major funding source
using a funding conduit.
In a typical
synthetic transaction, the borrower would have two
options at the expiration of the lease term. One
is to purchase the property from the lessor (or
owner) for the balance due. Because this amount
cannot be a bargain purchase, an appraisal is
required at the lease inception stating that the
amount is not a bargain price. The other option is
to sell the property on the last day of the lease
term to a buyer unaffiliated with the borrower and
guarantee the lessor any deficiency in the sale
proceeds up to a specified amount with any excess
payable to the lessee. Through a fixed-price
purchase option available at any time, lessees may
benefit from any appreciation in the underlying
value of the leased asset(s) even though such
assets are not owned for GAAP accounting purposes.
Alternately, lessees have the right to ''return''
such leased assets at the lease maturity upon
making a
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