While the predominant solution to Financial Interpretation No. 46 in the ABCP market has been the issuance of an expected loss tranche, some are questioning the actual function of these if bank administrators are going to protect the expected loss investor with the same vigor that they have historically shielded ABCP investors.

The market may be facing its first test through Citibank's handling of the Parmalat trade receivables exposure it purchased out of Eureka Securitization when the news broke that Parmalat was involved in fraud. While funding problem assets out of the conduits has been the common practice over the years, the advent of the expected loss tranche - which allows the administrator to achieve off-balance sheet treatment under U.S. GAAP - complicates the issue.

Most of these tranches have been structured into their corresponding conduit within the last six months.

According to market sources, this particular situation is moving through the regulatory ranks, and its resolution will likely be closely watched - and likely set some precedents. Officials and media contacts at Citigroup are not commenting in the least.

By contrast, Citibank had been public with the discovery of the receivables in its Eureka conduit back in January. Apparently, the bank had already removed the facility from Eureka by the time it made its announcements. Eureka executed the asset-purchase liquidity agreement, funding the $200 million out of the conduit as soon as its integrity was in question.

What's unclear at this point, however, if whether or not Eureka's expected loss investor - who is currently unnamed - will suffer a loss. At this point, it's not even clear that the receivables are impaired at all from a credit standpoint, as Citibank has yet to disclose additional information on the topic. What is clear, however, is that expected loss investors enjoy handsome yields (assuming they don't get wiped out), to the tune of 20%.

"These pieces are being sold with the intent that they're not ever going to draw on them," said one ABCP investor. "Even if they were sold with the intent that they are going to be drawn upon as a first loss, I don't think those things are sized anywhere near where they should be."

Of course with Parmalat and Eureka, no one really knows how this situation will play out. The loss tranches, though highly private and hardly standardized, apparently do follow (or remain exposed to) assets taken out of the conduit by the sponsor through liquidity. What hasn't been determined, however, is for how long. Again, it likely differs from deal to deal.

"The complicating factor is that when deals are removed from conduits and put on the bank's balance sheet, they're typically restructured - very few deals go to a true liquidation," said a conduit source.

Another source added that, "It would be very bad fact [for the market] if they bought it out at fair and take a loss shortly thereafter."

Expected questions

The debate over the last year (and perhaps much longer) has focused on whether consolidation of a conduit's asset and liabilities by the administrator paints an accurate picture of the administrator's risk to its conduits. Most in the industry - including the U.S. federal regulators, as expressed through the relief provided to ABCP-sponsoring banks - believe that consolidation does not accurately reflect the level of risk. The regulators instead require the banks to hold capital against eligible liquidity facilities.

The FASB, however, had tackled this issue with some controversy, as sizing the expected loss based on variable interests in an ABCP conduit was at first viewed (and is arguably still viewed) as a task plagued by ambiguity.

That said, FASB officials, including FIN 46 author Ronald Lott, are watching the developments in Eureka with much interest. Lott, for one, is concerned with the notion that liquidity losses may not be fully incorporated in the expected loss computation, if it is commonplace for sponsors to fund assets out of the conduits before they are officially impaired (while expecting them to be deemed impaired at some point).

Essentially, if a sponsor were to take a loss position ahead of the expected loss investor, off-balance sheet treatment may not be appropriate, in Lott's opinion.

The opposing argument is that, although conduits do pose a risk to the sponsor bank, it's not at the magnitude that full consolidation is ever appropriate. In contrast to some types of bank lending, for example, when something does go wrong in a receivables facility, the conduit has true ownership of the facility's assets, and recoveries would have different characteristics.

"The thing you have to remember about ABCP is that, fundamentally, it's a very conservative product designed for conservative investors with very low return profiles," said one conduit banker. "So it's not about hiding income, it's about preserving the low cost source of funding, which is beneficial to the borrowers, keeping funding costs down in the economy overall. The fact is that there's not enough yield in these deals for them to make sense to do this at 8% capital risk weighting, which would be the case if they were consolidated."

"Behavior by the conduit sponsor to insulate expected loss note holders from losses arguably undermines the off-balance sheet treatment for the conduit," said one bank researcher. "The factual question here is whether or not the sponsor did act to insulate the expected loss note holder."


Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.