Preliminary drafts of the Financial Accounting Standards Board consolidation project had been hotly debated and discussed by interested parties in the ABCP market for a number of months. The final exposure draft - which was released in June - is vague in places, and lacks several concepts from the preliminary drafts that would have added more clarity to ABCP and CDO participants.

Bank-sponsored multi-seller programs are the largest single category of ABCP programs. Moody's rates 140 Prime-1 multi-seller programs, with $408 billion outstanding as of 3/31/02, approximately 57% of the market.

In preliminary drafts FASB developed the concept of "silos." Under the silo concept the originator of the assets would be required to evaluate just its portion of the conduit's assets and liabilities for consolidation. However, if the silo is set up with an intervening "qualifying SPE" or QSPE as set up in accordance with the rules of FASB 140, it would not be consolidated with that the originator of the assets. In this case, if the ABCP conduit itself was not a QSPE (few, if any, multi-seller programs could qualify for QSPE status) then the transaction might be consolidated with the bank sponsor of the ABCP program.

Paragraphs 22 and 23 of the exposure draft (ED) deals with the consolidation of SPEs that hold financial assets other than equity securities. These sections cover most of the features of the "financial SPE" (FSPE), a concept that was the subject of much discussion in preliminary drafts. These appear to be the most directly applicable sections for multi-seller ABCP programs. The ED does not specifically mention the silo concept, but language in the ED, particularly paragraphs 17 & 22, seem to suggest this result.

The criteria in paragraph 23 seem to be directly applicable to bank sponsors of ABCP conduits. Paragraph 23 requires consolidation with the party providing "significant financial support through a variable interest" (read the bank sponsor) if the bank meets two of the following three tests:

* It has authority to purchase and sell assets and has sufficient discretion in exercising that authority to significantly affect the revenues, expenses, gains and losses of the SPE

* It provides guarantees, back-up lending arrangements, credit enhancement, etc. that is subordinate to interests of other parties

* It receives a fee that is not market-based

If it remains as is in the final issued Interpretation, the first point might result in careful redrafting of

conduit administration agreements. Administrators may require that the addition or divestiture of deals be based on strict objective criteria, removing a significant amount of the discretion that has been a feature of conduit management. Administrative discretion is an important part of the value-added function of an administrator. ABCP programs, particularly multi-seller programs, are dynamic vehicles that require flexible and responsive administration. It will be difficult to restructure these to an autopilot standard. An interesting additional issue is to understand exactly what the FASB means by "affect revenues, expenses, gains and losses" of the SPE. Conduits are structured to run on a break-even basis, and adding or removing assets doesn't change this.

Most sponsors would fail the second test. All bank sponsors provide a material level of liquidity and/or credit support to their ABCP programs. It is also very likely that the rating of the programs would not likely remain intact if the liquidity or credit enhancement were senior to CP. In many cases liquidity is pari passu to CP in program waterfalls, but credit enhancement is always subordinate. This may lead to farming out of credit enhancement to third parties - i.e. mono-lines, other banks or the term market - but many conduit sponsors may not wish to involve another player in its conduit operations.

The third point is vague: What exactly is a market-based fee? CP deals are negotiated at arm's length between the conduit and the seller of the assets. Conduits compete with each other for the same deals. This would seem to imply that all fees charged by the conduit are "market" based. On the other hand CP deals are private deals. Therefore, how can the information be obtained to prove that one conduit's fees are like another's and therefore market-based? Most bank administrators receive a spread over CP cost of funds, but this spread will be different from deal to deal, depending on the client, degree of risk and other factors. Presumably the fee is what the market will bear, in that the seller can go elsewhere.

The other side of the fee issue is that, as noted above, conduits are designed to operate at a zero net income. If all fee income is paid out to the administrator to get the conduit to zero net income, is that market-based? All conduits are designed this way, so it is, in effect, market-based. However, this feature could also be interpreted as the bank sponsor's holding the total variable interest in the conduit, undermining the market-based fee argument.

One final point raised during the preliminary exposure drafts, not specific to ABCP, was that if the SPE can replace the administrator at any time, that might be an indicator of a market-based fee. This provision is nowhere to be found in the final ED.

Credit Arbitrage Programs

The next major category of ABCP programs is the credit arbitrage program. Moody's rates 88 Prime-1 credit arbitrage programs and an additional 17 "hybrid" programs, with $192 billion of ABCP outstanding as of 3/31/02, approximately 27% of the market. These programs were established to provide regulatory capital relief by funding highly-rated securities that would otherwise be held on the bank's balance sheet. Because of variable interest criteria in the ED as well as the fact that sponsoring banks are so clearly the sole beneficiary of these programs, their likelihood of consolidation is quite high. However some of these programs are already set up as QSPEs, as they operate on enough of an autopilot basis for adding/removing assets to satisfy QSPE criteria. If they are not QSPEs, or if some other rule of the exposure draft trumps this, then credit arbitrage vehicles would likely be consolidated. All the tests of the FSPE as described above would likely be violated. In particular, conduit sponsors dividend out all spread left in the vehicle - a total variable interest that would likely fail the third criteria test. One offsetting factor is that the majority of Credit Arbitrage programs are sponsored by foreign banks that may not be subject to U.S. generally accepted accounting principles, and thus any FASB Interpretation.

Structured Investment Vehicles

The other major category of securities arbitrage programs are the Structured Investment Vehicles (SIVs). Most of these programs are offshore vehicles, with their sponsors based in London and their SPEs located in Jersey, Bermuda or the Caymans. Many may not be subject to U.S. Generally Accepted Accounting Practices, and therefore may not be affected by the eventual form of the Interpretation. However, in some cases the capital notes are owned by U.S. firms or their subsidiaries or other firms subject to U.S. accounting standards, and future programs may be set up directly by U.S. entities. Therefore it is useful to consider the impact of the ED on SIVs.

SIVs are considerably more dynamic than credit arbitrage programs in their operations and likely would not qualify as QSPEs. They operate more like CDOs and would likely fall under the categories of the ED that govern CDOs: either paragraphs 9 to 12 on voting interest or paragraphs 13 to 17 dealing with variable interests. These would be in addition to paragraphs 22 and 23 dealing with financial SPEs. These mandate consolidation with either the holder of the largest equity interest or the largest subordinated interest in the vehicle. For SIVs the question will be whether this applies to Capital Note holders (who are actually subordinated debt holders) or common equity holders.

One final point to note is that SIVs issue material equity (5% to 8%), unlike other ABCP conduits. The ED considers 10% equity as the minimum sufficient to demonstrate that the SPE has enough substance to finance its own activities. The first question here is whether the Capital Notes qualify as equity. In this same section it is possible to justify a lower level of equity if the amount is comparable to that of other businesses that are not SPEs. So the second question is whether one can find a real company that is comparable to a SIV, one that might be open to much interpretation. Of course, a SIV could raise its equity to 10% or greater. Raising equity and Capital Notes financing can be a challenge to SIVs. However, SIVs may be able to expand their eligible investment criteria with a higher equity level, covering the added cost.

Meanwhile, single seller programs are generally set up by non-bank corporations to finance assets associated with their own business. Moody's has Prime-1 ratings assigned to 56 of these programs, with $84 billion of ABCP outstanding, approximately 12% of the market. While banks often provide support in the form of liquidity facilities or letters of credit, consolidation of these vehicles with those banks is not an issue. Either they would be consolidated with the corporate sponsor, or, more likely, they can be structured as a QSPE and exempt on that basis.

More ED Questions

Still left unanswered is the effect of a QSPE's strict rules for derivative holdings relative to the derivatives that are normally held by ABCP programs. Even if the FSPE tests are passed, the strict derivative limitations may lead to a consolidation problem. The normal interest and fx swaps held by ABCP programs will likely meet these criteria.

Also up in the air is the effect of ABCP programs' relatively unfettered ability to issue and reissue beneficial interests (read CP). This may also affect FSPE and/or QSPE status.

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