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4 PATHOLOGY OF DEBT PART 5: Off-balance-sheet
debt By
Henry C K Liu
residual
payment, assuming there is no event of default and
certain return provisions have been satisfied.
Implementing synthetic leases has led to
unique and bleeding-edge structures (beta
testing), which are highly influenced by
accounting and tax rules. FASB new rules regarding
SPEs, including those involving synthetic leases,
would make it much harder, if not impossible, to
make use of such arrangements when
they
involve SPEs. Some companies such as Symantec
Corporation continued to use synthetic leases to
keep real estate financing off their balance
sheets. Symantec defended its practices by
pointing out that the arrangements met new
accounting rules because its synthetic leases did
not involve SPEs. But most lenders have to get a
regulatory exemption to offer such leases without
the use of SPEs, and only a handful have done so.
While
the debt reflected by Symantec's synthetic leases is
kept off the balance sheet, the amounts involved
are footnoted on the balance sheet
under "restricted cash". Krispy Kreme Doughnuts Inc
unwound a non-SPE synthetic lease that was slated to
finance a new mixing plant in Illinois, and instead
carried some $33 million to $35 million of the debt
on its balance sheet. Cisco Systems Inc also
decided to abandon its use of synthetic
leases, announcing that it would unwind all the leases it
had used to finance its San Jose, California,
headquarters and several manufacturing facilities
in California and New England. Cisco consolidated
roughly $1.6 billion in real estate assets
by the end of the last fiscal year, betting that
it was better to have investors see a bigger balance
sheet than suspect that it was hiding debt.
When Sears returned $8 billion in credit
card receivables from an SPE to its balance sheet
in early 2001, the company's ROA dropped from 3.6%
in 2000 to 1.6% in 2001. Even so, Sears's stock
soared by almost 70% as a result of the change
toward more transparency.
Skepticism about
General Electric lingers. Toronto-based
credit-rating agency Dominion Bond Rating Service
figured that if all of GE Capital's
off-balance-sheet securitizations were added back
to the debt it consolidated as of year-end 2001,
the finance subsidiary's leverage ratio would rise
from 13.5 times tangible assets to closer to 16
times.
The activities conducted through
SPEs in the asset-backed securities market now
raise the same issues of disclosure and hidden
risk as did the Enron disaster. More than a
trillion dollars of assets were taken off
corporate balance sheets in 2006 and put into SPEs
and commercial-paper conduits. That amount makes
Enron look small-time.
Commercial banks
use SPEs to securitize their own assets and also
sponsor ABCP conduits, which purchase and
securitize assets from third parties. New
accounting rules for these activities will cost
both banks and their corporate borrowers. With
FASB rule 157 coming into effect on November 15,
2007, banks are required to consolidate their SPEs
to add a lot more assets on their balance sheets
and hence will have to raise capital to meet
regulatory reserve requirements. Banks and
near-banks may then be compelled to rein in their
SPEs and conduit programs, and the terms for both
loans and asset-backed commercial paper will
tighten. Moreover, without the liquidity
guarantees provided in bank-sponsored conduits,
many companies might lose their access to the
asset-backed market altogether.
Creating liquidity out of illiquid
assets The ability to create liquidity out
of illiquid assets by packaging them into
securities has been the most significant
innovation in the capital markets in the past two
decades. Since Fannie Mae and Freddie Mac started
the trend in the mortgage market as part of their
official mandate from Congress to foster more home
ownership, securitization has expanded into a
variety of credit markets. This was not a problem
when the relationship between asset value and debt
was kept within normal bounds.
At some
point, asset securitization shifted into debt
securitization as the debt bubble expanded from
the Fed's loose monetary policy coupled with the
Treasury's abuse of dollar hegemony, using the
capital account surplus to finance an expanding
trade deficit. Asset-backed securities were
eventually overwhelmed by collateralized debt
obligations, backed by payment streams from
credit-card debt, auto and home-equity loans,
commercial mortgages, and trade receivables beyond
consumers' ability to carry once the temporary
wealth effect of astronomical asset appreciation
fueled by massive debt ends.
Asset-backed
securitization allows originators to monetize
illiquid assets and remove them from their balance
sheets to devote the proceeds as new capital to
finance growth. The macro-economic benefit of
securitization is that it has enabled the
extension of credit to far more individuals and
businesses in the US. The macro-economic cost of
securitization is vastly expanded systemic risk of
default in a debt bubble, especially when the
debts' proceeds are largely devoted to financing
more debt rather than real investment for
expansion.
Securitization of debt fed
the debt bubble As the debt bubble
expanded, industrial companies began to look for
profit from financial engineering, a respectable
euphemism for manipulation. The problem was
exacerbated by outdated financial-reporting
practices that failed to keep pace with
securitization innovation, thus allowing debt
proceeds to be swapped with counterparties as
current income and payment of principle counted as
long-term capital investment. Debt liabilities
then magically disappear from corporation annual
reports. Programs executed in SPEs
off-balance-sheet kept investors in the dark about
the risks involved in their high-yield
investments.
As early as 2002, Pacific
Investment Management Co (PIMCO) bond fund manager
Bill Gross 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 CP
market was becoming precarious. See my AToL series
on central banking: Banking Bunkum - Part 3d: The Lessons
of the US experience
Paying for bad loans made in
good times As the biggest players in the
structured-finance market, commercial banks in the
US and Europe may have to face up to the real
liabilities of their SPEs. Several studies of
securitization programs by ratings agency S&P
showed that all the major banks, and many minor
ones, conducted significant off-balance-sheet
securitizations through their own SPEs and through
commercial paper conduits. Conduit programs alone
financed approximately $500 billion in assets in
2006, none of which appeared on corporate or bank
balance sheets, except as minor footnotes.
Securitization has enabled banks to
finance assets through the capital markets, but
the process has not eliminated associated risks
for banks. 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 profitably when the economy is
strong and expanding and credit losses are small
as easy and low-cost credit can bail out trouble
loans, as was the case through most of the 1990s.
But as former Federal Reserve chairman Alan
Greenspan was fond of rationalizing: "Bad loans
are made in good times." He never bothered to
finish the second half of the truism: "No loans
are made in bad times," a fatal fact when the
economy depends on the roll over of existing debt.
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. But that happy state of
affairs will end in one week's time.
FASB Rule 157 Financial
Accounting Standards Board (FASB) rule 157,
effective November 15, 2007, will make it harder
for companies to avoid putting market prices on
securities considered hardest to value, known as
Level 3 assets. Level 1 assets are mark-to-market,
based on liquid real prices. Level 2 assets are
mark-to-model, an estimate based on observable
inputs and used when no quoted prices are readily
available. Level 3 assets are those the value of
which is based on "unobservable" inputs reflecting
companies' "own assumptions" about the way assets
would be priced.
At stake is the value of
the assets on bank balance sheets, ie liabilities
of increasingly complex and esoteric instruments,
such as ABS (asset-backed securities), MBS
(mortgage-backed securities), CDS (credit default
swaps), CDO (collateralized debt obligations) and
similar instruments.
Level 3 assets are
those that are so complex, or so remote from the
initial underlying assets because they have been
sliced, repackaged, resliced, repackaged and
combined with other bits, that there simply is no
way to reliably calculate what they are
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