FASB’s post-Enron crackdown on funding of assets with collateralized notes and
bank-sponsored CP conduits has no easy solutions.
n January, the Financial Accounting Standards Board (FASB)
I released FIN 46, an interpretation of Accounting Research
Bulletin No. 51 (ARB 51), which addresses consolidation of
so-called variable interest entities. The impetus was primarily
Enron and its accounting abuses with respect to special purpose
FIN 46 specifically relates to the funding of assets through
collateralized notes funded by commercial paper conduits (CP
conduits). A number of issues and efforts have emerged since
then, as financial professionals come to grips with this new round
of FASB action.
The stakes are high. According to research by Wachovia
Securities, there were $726 billion assets in CP conduits
outstanding by year-end 2002, primarily bank-sponsored. Even
the few non-bank sponsored CP conduits usually obtain their
liquidity facilities from banks.
Remarkably, there were only $9 billion in outstanding CP con-
duit assets in 1988. The rapid growth of corporations
utilizing CP conduits as an efficient funding source has been
sparked primarily by a low cost of funds available through this
bank-sponsored capital markets funded technique.
Here’s How it Works
Adrian Katz The funding process typically works this way. A corporation cre-
CEO and Director ates a wholly-owned SPE and sells some type of cash-flow assets
Financity Corporation to this SPE (thus taking those assets off its balance sheet).
financial accounting & reporting
The SPE sells a security to a CP leases and loans. Accounts terms, a potential swing in corporations.
conduit, collateralized by the receivable represent about one- excess of $700 billion of assets Unrelated to CP conduits or
cash-flow assets. The CP con- third of all CP conduit assets onto the balance sheets of any financing transaction,
duit sells commercial paper (CP) and can be found on almost banks might cause huge, a somewhat strange consen-
to capital market investors to any corporation’s balance sheet. adverse ramifications affecting quence to FIN 46 was recently
finance its purchase of the col- CFOs often consider these the way corporations access the revealed in an SEC filing by
lateralized security. The funds assets, typically short-term, to capital markets. Cisco Systems Inc. The com-
flow back to the selling corpo- be the best non-cash asset on pany said it would take a
ration via a chain that links CP the balance sheet. After all, One Exception non-cash charge of up to $500
investors, CP conduits and the goodwill assets can be flaky or One glaring exception, at least million in connection with an
SPE issuance vehicles. tough to quantify, while plant, for the near term (probably acquisition, as a result of FIN
Because the selling corpo- equipment and inventory through the end of 2004), is 46 consolidation requirements.
ration is essentially anonymous might be illiquid. non-U.S. banks. They are typ- Other such situations may well
to the ultimate investor in this As a direct result of FIN 46 ically subject to International exist across corporations of all
scenario, corporations can and assuming no ameliorating Accounting Standards (IAS) types and sizes.
access capital markets for finan- action due principally to the and not FASB. Allegedly, the
cial liquidity via CP conduit nature of bank credit enhance- Office of the Comptroller of the Beyond Subtle
securitizations affecting the ments and equity-like variable Currency (OCC) might provide Nuances
primary or secondary market interest cash flows, CP conduits temporary regulatory relief to Generally, new accounting rules
for its other capital market must be consolidated on the banks, buying time for them to are relevant to a rarefied group
issues, including any unsecured sponsors’ balance sheets. find a solution to accommodate of accountants and finance pro-
commercial paper. The problem: Such consol- consolidation implications. By fessionals responsible for
idation will likely decrease itself, this potential action by implementing the technical
Eligible Assets availability and increase the the OCC suggests the magni- nuances. In the instance of FIN
Examples of typical eligible CP cost of financing via asset- tude of implications and prob- 46, the consequences may
conduit cash flow assets backed securitizations funded lems that FIN 46 poses for both prove to go well beyond subtle
include accounts receivable, by CP conduits. In broader the banking community and adjustments and will likely
4 September/October 2003
financial accounting & reporting
require the attention of many the bank is resigned to sim- duits pursuant to Paragraph 14 alized by the transferred assets.
corporations that heretofore ply bringing the assets back of FIN 46: The SPE usually remits the pro-
have not considered its signif- on the balance sheet, at least ceeds to the seller.
icant ramifications on the cost for now. For some CP con- 14. An enterprise shall consoli- The CP conduit equity,
and availability of capital. duits, this scenario could be date a variable interest entity if distinct from the SPE equity,
tantamount to exiting the that enterprise has a variable is subject to certain risks and
Banks Face Lower CP conduit business, a path interest (or combination of vari- rewards, and thus is described
Return on Equity already chosen by one sig- able interests) that will absorb a as a so-called variable interest.
Banks have essentially em- nificant player. majority of the entity’s expected Bank sponsors generally retain
ployed 0.8% capital to support 2) Form cooperative equity ven- losses if they occur, or both. An variable interests, which absorb
CP conduit activities. As such, tures between bank sponsors enterprise shall consider the rights performance losses of assets
if a stereotypical investment so risks and rewards are
grade customer received fund- shared sufficiently, and no
ing at CP + 25 basis points single entity is required to con-
(bps) prior to FIN 46, the bank solidate. This approach will Consolidation will likely
sponsor would generate a re- likely require sponsors to
turn-on-equity (ROE) in excess relinquish control and decrease availability and
of 30% (80 bps of equity cap- subject themselves to the
ital returning 25 bps). discipline (or lack thereof) increase the cost of financing.
With the advent of FIN 46, and performance of unre-
the same CP spread (25 bps) lated partners. In addition,
will produce substantially lower daunting restructuring of and obligations conveyed by its before CP investors incur them
ROEs (800 bps of equity capital existing paperwork might variable interest and the rela- — thus the associated descrip-
returning 25 bps = 3.1%) com- be necessary. tionship of its variable interests tor “first loss.” Per Paragraph
parable to government bonds. 3) Sell off enough equity (first- with variable interests held by 14, the consequence is that the
Based on the $726 billion of loss risk) to third parties to other parties to determine entity deemed to retain the
assets outstanding at year-end justify to auditors that consol- whether its variable interests will variable interest risk must
2002 in CP conduits, banks idation should transfer with absorb a majority of a variable consolidate.
would require more than $50 the sale of variable cash flows. interest entity’s expected losses, There are two component
billion in additional equity to This route will probably receive a majority of the entity’s steps:
support such activities. require: 1) an auditor- expected residual returns, or both.
approved algorithm for siz- A direct or indirect ability to make 1) Resolution of an algorithm to
Seeds of a Solution ing the minimum equity decisions that significantly affect size the amount of equity neces-
Creative thinking and elbow sell-off necessary to support the results of the activities of a sary to be transferred, which
grease are assisting bank spon- deconsolidation, 2) the abil- variable interest entity is a strong results in off-balance sheet treat-
sors in FIN 46 compliance, ity to adequately evaluate, indication that an enterprise has ment for the seller
while also attempting to control and monitor risks, one or both of the characteristics
achieve off-balance sheet treat- and 3) significant third- that would require consolidation This is a very complex task.
ment. So far, there are no party equity capital. Regu- of the variable interest entity. If First, the accounting profession
silver bullets.However, you latory approval might also one enterprise will absorb a hasn’t stated its willingness to
should know that most bank be required. A subtlety is majority of that entity’s expected delineate an algorithm based
sponsors are considering three that the first-loss risk could residual returns, the enterprise on the requirements. FIN 46
principal routes: be provided through a lia- absorbing a majority of the losses doesn’t provide precise guid-
bility construct, such as a shall consolidate the variable ance and accountants seem
1) Take no evasive accounting guarantee, as opposed to an interest entity. uncomfortable to go out
action and simply consolidate. equity investment. on a limb.
This route will translate into In typical CP conduit- Some accounting profes-
significant adjustments in Let’s examine this third funded, asset-backed securiti- sionals have sought clarifying
pricing and/or credit stan- option more closely. zations, sellers form their own guidance from FASB, but so far,
dards to justify additional Solutions SPE and sell assets to their received limited response.
capital. JPMorgan Chase’s Create an entity to purchase wholly owned SPEs. Invariably, FASB Staff Positions (FSPs)
CFO indicated on a recent equity interests (first-loss cash this SPE creates and sells to a recently provided some insight
earnings conference call that flows) from existing CP con- CP conduit a security collater- on how fees a variable interest
AFP Exchange 5
financial accounting & reporting
entity pays to a guarantor of the it to absorb 100% of losses, leav- very discontinuity of fraud, past small and any eventual
entity’s assets or liabilities affect ing no remaining value. performance may not be much methodology will result in
determining the variable inter- One of the problems is of a predictor. higher requirements.
est entity’s primary beneficiary. evaluating past credit loss expe- Recent apparent fraud Whatever the ultimate first-
While this provides some rience for any given CP con- includes the failure of National loss size requirements, the incre-
guidance, it doesn’t outline for duit. Often, when an adverse Century, in which bank- mental cost to CP conduits will
the seller how to size equity for credit event occurs, the bank sponsored CP conduits funded probably be at least several basis
off-balance sheet treatment. sponsor has simply purchased several hundred million dollars points, possibly more, assum-
There are mixed hopes that the troubled assets out of the of allegedly hypothecated assets ing appropriate equity returns.
FASB will provide additional CP conduit at a price of par and with disastrous consequences. On the issue of risk and
guidance. managed the consequences on The dollar amounts involved return, most banks seem to
Also, the role and perspec- its own balance sheet. represent several percent of the reject sharing risks with other
tive of bank regulators needs In some situations, the ulti- afflicted CP conduit assets. The bank sponsors. If risks were
to be accommodated. Any mate resolution of a challenged CP investors weren’t adversely truly as limited and predictable
acceptable algorithm will need asset pool might take years to impacted — the bank sponsors as banks claim, why wouldn’t
to be grounded heavily in fact unfold. Thus, the true risks and paid the piper. they share them with other
and analytic support, focusing credit losses experienced by CP There has been a spate of institutions?
on past and predicted losses. conduits have been masked. trial balloons on the appropri- Bank-sponsored CP conduits
The amount of equity should Even if a CP conduit and its ate size for an equity transfer. employ credit professionals to
be at least large enough to sponsor fully disclosed past The most recent amount evaluate transactions and mon-
absorb expected losses. A mul- performance, they might be floated was 0.1% (10 bps) as itor portfolio exposures. If CP
tiple of expected losses might hard-pressed to reconstruct the noted in Business Week April 28, conduits sell risks, we need
even be required. No equity facts. Further, significant large- 2003. This author suggested mechanisms to maintain
investor would reasonably pur- scale risk events have usually that amount and other sug- credit disciplines.
chase an investment expecting resulted from fraud. Due to the gested percentages are too Of course, the rating agen-
6 September/October 2003
financial accounting & reporting
cies are also involved in the third-party, asset-servicing plat- might be expected to provide Given the sheer size of CP con-
credit review process as the CP form, doesn’t exist currently for additional fraud detection duit liabilities outstanding, it
issuances of CP conduits are any CP conduits. But such through collateral verification, may not be overly dramatic to
rated, typically A1/P1. It’s note- components will probably be both up-front and ongoing note that the very availability
worthy that borrowers that required for equity investors. (especially pertinent for and cost of financial capital
obtain funding from CP con- CP conduits currently oper- revolving asset structures). for corporations might be
duits invariably retain, assume ate with a black-box approach Fraud is the single biggest impacted severely if solutions
or guarantee certain risks. to investor reporting. Tracking source of unexpected and aren’t successfully developed
Certainly, the rating agencies risks behind the typical CP difficult-to-prevent losses. Most and implemented. CP conduit-
could be an important partici- conduit curtain is characterized servicing of assets in CP con- funded, asset-backed securiti-
pant in developing reasonable paradoxically as both crucial duits is conducted by the very zations, in the absence of
loss assumptions and equity and yet, as practiced, inherently party borrowing against the tangible progress toward solv-
sizing algorithms. imperfect. assets, thus causing a fox-in- ing FIN 46 challenges, will
the-henhouse problem. likely face substantive disloca-
2) Implementation of a credit and Third-Party Support An equity investor might tions resulting in higher costs
fraud risk monitoring and detec- To the extent that an asset pool require a third party to admin- for corporations. The seeds of
tion platform. and/or servicer involved in a CP ister lockboxes and/or blocked any such solutions have been
conduit becomes distressed, an accounts, thereby controlling planted and market partici-
Ongoing credit performance equity investor could require a cash and its appropriate alloca- pants need to see what’s
monitoring and fraud detection third party to step into the tion on behalf of all constituents, ultimately harvested.
is difficult and requires a sus- breech and support any servic- such as CP investors, borrow-
tained effort. Sophisticated asset ing challenges that develop. ers and the equity investor.
performance transparency, cou- Further, some entity, pos-
pled with a comprehensive sibly the back-up servicer, Final Thoughts
Adrian Katz currently serves as CEO and director of Finacity Corporation, a joint venture com-
pany with Amroc Investments, ABN AMRO, Bank of America, EULER American Credit Indem-
nity, Kleiner Perkins Caufield & Byers, Bain & Company and Texas Pacific Group. Katz has 18
years of experience both on Wall Street and as a lender.
AFP Exchange 7
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