As the Street absorbs the shockwaves engendered by the recent slew of big-name mergers, observers are simultaneously bracing for the cloud of regulatory and accounting changes looming above the financial markets - changes which will not only feed the ongoing trend of consolidation but may ultimately determine which players enter or exit the debt sectors over the next few years.
The Financial Accounting Standards Board's recent re-thinking of its proposed ban on pooling-of-interest accounting for mergers, coupled with the inauguration of FAS 133 and the amendments to the ERISA "Underwriter Exemptions", should provide an interesting beginning to the year 2001.
The FASB had voted last year to explicitly eliminate pooling-of-interest accounting by January 1, 2001, meaning that companies would be required to use purchase accounting to record every merger or acquisition. Acquirers tend not to like purchase accounting because it forces them to take additional depreciation and amortization charges that dilute reported earnings and can trigger a negative market response.
However, FASB announced last week that a compromise offered in recent months by banks and other financial service firms - an alternate methodology that would retain some of the benefits of pooling-of-interest accounting - was being seriously considered, and some of the "sting" of the proposed ban would be removed.
Some industry analysts believe that the string of recent mega-mergers were timed prudently, as time was running out to take advantage of the soon-to-expire pooling of interest method - but now that this method might remain as it is, this would add fuel to the growing trend of consolidation on the Street, sources say.
"Some people have argued that the pooling method should be retained for mergers of equals, meaning that, if two firms are equal, you can't tell who is buying who," said Todd Johnson, a senior project manager at FASB. "But it is not completely clear whether a choice of accounting method is driving these recent transactions. Transactions should be driven by economics. However, there must be some companies out there that were trying to get in under the wire, before the proposed ban took effect."
"This questioning of the ban on pooling-of-accounting methodologies surely makes further consolidation seem more likely, which means there are fewer players in the securitization markets, which will result in even less liquid markets," said an MBS investor.
"To me, this clearly is a case of the tail wagging the dog, and with further consolidation, there is nothing to stop a powerful entity from wielding power in the markets," said another market veteran. "Clearly it seems to me the anti-trust process should get involved, eventually."
Impacting the IO/PO Markets
This has certainly been a big year so far for mergers, acquisitions and consolidation on the Street, and with the additional impact and uncertainty of FAS 133 going into effect next year, the continuing ramifications of consolidation on originators might lead some players to exit the mortgage market altogether, sources say.
As companies start to deal with FAS 133 next year, companies are expected to sell large amounts of mortgage servicing.
"The pooling of interest made it difficult for servicers to use hedge accounting, because FAS 133 seems to require draconian methods for how you track value in a portfolio," said Jeffrey Ho, an analyst at PaineWebber. "It used to be that derivatives could qualify for hedge accounting, but FAS 133 took that away, and in the last couple of months there has been lots of interest from servicers for PO (principal-only) products."
"This change in regulations has put pressures on the way interest-only (IO)-type cashflows are valued, which is an issue for banks," added Michael Hoeh, an MBS investor at Dreyfus Corp. "There was a fear in the market that the change in regs would lead banks to sell more IOs and require them to have more POs on their books. This month, therefore, there was a pretty strong bid to the PO market, and IOs were underperforming for awhile."
Additionally, FAS 133, a new accounting standard for derivatives and hedging, has led mortgage originators to purchase principal-only (PO) strips to hedge their servicing books. Sources say that the increased volatility and consolidation caused by FAS 133 will cause every originator to determine what they do best, and where they find and add value.
Further, the impact of hedging the servicing asset will mean that lenders' income statements will be burdened by the additional costs of servicing, and earnings volatility will increase.
"Many companies may not be able to deal with the volatility, and will seek to exit the [mortgage] market," said an MBS analyst.
Erisa and the CMBS Bid
Finally, the last regulatory hurdle involves the impending ERISA amendments. In response to an application filed by the Bond Market Association, the U.S. Department of Labor has issued for public comment amendments which will significantly expand the ability of private pension plans to invest in asset-backed, mortgage-backed and commercial mortgage-backed securities.
One of the most frequent buyers of commercial mortgage IOs were Erisa accounts, because they could not invest in subordinate CMBS. So in order to get the same type of spread and exposure to the commercial real estate markets, Erisa accounts were buying CMBS IO for their portfolios.
Now, with the Erisa laws changing, some sources indicate that there could be a less developed bid for CMBS IOs.
"If you're an Erisa account and you happen to own CMBS IOs, you might be better off going to single-A-type credits," said a CMBS trader. "You might expect CMBS IOs to cheapen up dramatically, though we haven't seen that yet."
The IO component of CMBS deals have actually priced well recently, but one investor was a little suspicious: "As for Erisa portfolios, I think you're going to see a change in value as the Erisa legislation goes into effect."
