• Strategy
  • CFO Asia

Through the Looking Glass

When is balance-sheet financing not balance-sheet financing? When it's done through a conduit.

The conduit, that odd species of special purpose entity, is all the rage among the region’s universal banks. Citigroup, HSBC, Standard Chartered, ING, Bank of America and ABN AMRO make wide use of them for the simple reason that conduits allow them to exploit an equally peculiar regulatory loophole in their funding.

But to understand precisely why the likes of Citigroup, tarnished in scandals emerging from Enron’s misuse of special purpose entities, or SPEs, would be advocating the use of them in Asia takes some doing. Why? Because conduits involve a lot of fancy footwork to off-load risk. They allow banks to move loans off the balance sheet into a vehicle that transforms them into capital-generating assets. Since the SPEs remain in a banks’ possession and make money, they offset the cost of offering loans at below-market rates to cement banking relationships.

Somewhere in the process, the risk tied to the underlying asset simply vanishes – or so bankers say.

Here’s how the money passes through the looking glass. Banks offload assets such as bonds, receivables, ABS programs, et cetera into the SPE. They then issue short-term commercial paper against these assets at very cheap rates, about seven to 10 basis points below Libor. The basic idea: banks fund their conduit programs with cheap commercial paper, and then on-lend this money into longer term and higher yielding investments. Conduits work because they match cheap short-term funding with these richer assets.

Green Cards

Banks can take advantage of this interest-rate arbitrage to lend at below market rates. A recent deal serves as an example. In February, Bank of America lead managed a five-year, US$300 million credit-card securitization for LG Card, and promptly put the deal into its Kittyhawk conduit.

David Ahn, LG Card’s manager of asset securitization team, said the deal carries a coupon of 45bp and that LG Card paid Bank of America a US$1 million arranger fee. The all-in payout of the deal comes to about 55bp, and Bank of America structured the transaction to an implied double-A rating. Assuming all these terms are accurate (bankers from rival institutions are skeptical) the deal is rock-bottom cheap.

By comparison, UBS and CSFB led a similar five-year securitization for LG Card in 2001. That triple A-rated deal was guaranteed by insurer FSA, and it carried a 55bp coupon. Counting the FSA costs and arranger fees, the deal paid an all-in of just over 100bp – almost twice as expensive as the Bank of America deal.

As a conduit transaction, the Bank of America deal is entirely private and it is hard to confirm all the details of the transaction. For example, there is talk that this deal carries a one-year early amortization trigger – effectively a one-year put for Bank of America, which would make it average priced (Ahn denies the deal comes with such a trigger).

Nevertheless, the deal’s conduit feature did make it cheaper than a normal capital markets’ transaction, much like the UBS/CSFB deal. “Because our conduits are funded from the US [short-term] commercial paper market at triple-A funding, that benefit is being passed along to the LG Card. That’s why we can be a little bit flexible on the pricing,” says Heesuk Noh, Bank of America’s vice president, asset securitization group, who was involved in the LG Card deal

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