Longer Paper Routes

Banks have gone to greater lengths to keep assets off their balance sheets. That means higher prices for commercial paper.

Once upon a time, everyone in the asset-backed commercial paper (ABCP) market was happy. Companies got access to cheap financing and bankers reaped lucrative fee income.

The recipe? A company sells trade receivables or other high-quality assets to a bank-sponsored entity known as a conduit. The conduit pools those assets with those from other companies. The bank provides liquidity and credit enhancement to cover potential losses in return for fees. And the conduit issues commercial paper, the proceeds of which are used to buy more assets. Critically, the financing of those assets is not reflected on banks’ balance sheets.

But Enron’s implosion in 2001 convinced regulators that the good times for ABCP and other forms of off-balance-sheet financing had gone too far. So last winter, the Financial Accounting Standards Board issued a new rule, called Financial Interpretation No. 46 (or FIN 46), that requires companies that control off-balance-sheet entities that generate variable interests to shift the assets and liabilities of those operations onto their balance sheets. The ruling was meant to prevent companies from doing what Enron did—using off-balance-sheet entities to hide debt.

Because it applies to ABCP conduits, FASB’s proposal threatened to curtail access to this inexpensive source of capital. But after intense analysis of the new rule, which took effect last July, banks have found it possible to cost-effectively restructure the conduits instead of consolidating the assets and liabilities. Most of the banks have just finished the job, which will be reflected in their third-quarter results. The bottom line for corporate participants: ABCP financing will remain available, but at a higher cost. It remains to be seen whether that extra cost will make the financing less attractive than the alternatives.

Perhaps it should be. Some critics contend that continued off-balance-sheet activity of this sort poses a risk to the health of the financial system (see “Conduits to Hell?” at the end of this article). Much, of course, depends on the course of the economy, simply because a recovery could mitigate much of the risk.

Financial Reengineering

It’s clear that FIN 46 makes life more difficult for banks sponsoring conduits. Under the rule, the primary beneficiary of a traditional ABCP conduit is now required to consolidate the assets and liabilities on its balance sheet. The rule says that the beneficiary is the party that stands to absorb the majority of expected losses, to reap the majority of the operation’s expected returns (portfolio gains or fees), or both.

The banks involved in this business have played both roles. Under FIN 46, it first appeared that the banks would have no choice but to bring conduit assets and liabilities onto their balance sheets. This was no small matter. Conduit assets often run into the tens of billions of dollars—about $20 billion for JP Morgan Chase, $39.5 billion for Bank One Corp., and $55 billion for Citigroup. Typically, conduit assets represent about 5 to 10 percent of total bank assets, says David Reavy, a partner with KPMG LLP’s financial-services practice. The capital required as a reserve on these assets would equal 8 percent of the total, which would have led to a commensurate reduction in a bank’s return on equity. Raising ABCP prices to bring ROE to previous levels would not have been realistic. “It would certainly depress the conduit market,” says Mellon Financial Corp.’s Jonathan Widich, manager of its multiseller ABCP program. “It doesn’t give an advantage to this type of financing over [traditional] corporate lending.”


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