In more post-Enron Corp. buzz, new rules being discussed by the Financial Accounting Standards Board (FASB) could throw a wrench into the CDO machine. Among other issues, last Wednesday the FASB said it may triple the amount of outside equity capital required for non-qualifying special purpose entities to receive off-balance sheet treatment.

The prospect of this new rule, which has been looming over the market for the past several weeks, was a hot topic at certain panels during Information Management Network's CDO 2002 Conference, held last week at the Crowne Plaza Hotel in New York.

While current rules state that only 3% equity needs to be placed with a third party investor, a revised draft of FASB 94 - which focuses on SPE consolidation issues - will likely state that an SPE will have to place at least 10% equity interest of the total capitalization with a third party or be consolidated on balance sheet. This equity must be subordinate to all other equity and debt classes.

The draft is expected to be out for review soon, and, following a commentary period, could be in effect toward the end of the third quarter.

The implementation of this rule would theoretically send new issues back to the drawing board, as today's CDOs, especially the investment-grade cash-flow variety, are generally structured with less than 10% equity to start. Increasing the equity would decrease the leverage that is required for the deals to make sense economically.

"It would strip all the juice out of the deal," a source said.

Similarly, entities such as banks, which often use CLOs to transfer risk off their balance sheets, might find it less economically attractive a solution, even with the regulatory relief that balance-sheet deals afford.

Apparently, there would be no grandfathering if these rules went through, meaning that existing SPEs would be subject to the new consolidation criteria.

So who would bear the brunt of FASB 94?

According to market participants, some CDO issuers, such as hedge funds and private asset management shops, are not subject to FASB accounting rules. In fact, these houses could benefit if the universe of deal managers subject to FASB accounting, such as insurance companies and banking entities, suddenly dissipated.

It is important to note that FASB is not referring to qualifying SPEs (QSPEs), which are used by the lion's share of the securitization market. Most CDOs do not qualify for QSPE treatment because there is a collateral manager, which can trade in and out of positions.

"I think an important statement is that FASB does not view this as a securitization project," said Marty Rosenblatt, head of the securitization practice at Deloitte & Touche. "They are looking at SPEs that are used for a variety of other situations, including research and development funding activities (R&D), synthetic leases, inventory product financing arrangements, and natural resource exploration activities."

Regardless, at least one CDO analyst believes that the market will experience a degree of volatility until these issues are resolved. However, that same analyst thinks that when the draft goes out for commentary, the accounting and banking community will oppose such provisions, and FASB could revise the rules again before putting out its final interpretation.

"Enron clearly accelerated all this," said Anthony Thompson, a CDO researcher at Deutsche Banc. "And what's frustrating is that, if you went back and applied a lot of these tests and rules with Enron, these problems still probably wouldn't have been averted."

If these rules were written into effect as discussed at last Wednesday's meeting, some researchers believe the market would adapt by creating new structures, perhaps utilizing static pools or closed-end deals more frequently, which could be structured as qualifying SPEs.

Said Deutsche Banc's Thompson, "A static pool deal, because of the absence of active trading, could probably be structured to meet the QSPE criteria."

Multi-seller conduits

Still on the plate, FASB is looking at consolidation issues related to companies that sell assets into multi-seller conduits. The accounting board will either meet again this week or the following week to discuss this topic.

"A substantial portion of the ABCP market uses the market to remove assets from balance sheet," said an ABCP banker. According to the source, many issuers, such as market leader GE Capital (via Edison Securitization), are not using ABCP for cheaper funding, but primarily for the off-balance-sheet treatment.

"This could really decrease some of the motivations to use ABCP," the source said.

Under current FASB accounting rules, neither the seller nor the conduit administrator consolidates the SPE, although it's possible the independent sellers will be made to consolidate their facilities on balance sheet.

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