From private investors to the Financial Accounting Standards Board (FASB) to President Bush, just about everyone is slashing back lately at the thicket of corporate accounting and disclosure issues sown by Enron and cultivated by the likes of WorldCom. And while no one has a problem with flushing out the crooked dealers, at least one market participant feels that some real estate players, with some help from the media, have been too quick to run roughshod over one instrument - the synthetic lease - in the process.

As reported in Private Placement Letter (ASR's sister publication), FASB has been on the front lines of the effort to prevent future Enron-esque abuse of off-balance-sheet vehicles as a smoke screen to conceal debt, working to adopt stricter rules concerning when a special purpose entity should be consolidated into its parent.

While the FASB issues surrounding SPEs will affect many leases - not just synthetics - the media, including PPL, has reported extensively on the uncertain future of the instrument and the possible fallout from its potential demise.

One banker has described the synthetic lease as a "contortion of reality" - allowing the lessee to benefit from the off-balance-sheet treatment with respect to the lease and any associated debt-related risks borne by the lessee and its investors, while at the same time reaping the benefits of tax ownership.

But another market participant familiar with the situation says that too much attention has been paid to the off balance sheet aspect of synthetics, pointing out that SPEs are often successfully used to accomplish objectives other than accounting results.

Bad rap?

Banks often use trusts for synthetic leases to shield themselves from liability associated with owning real estate (general and environmental), and lenders like to insulate themselves from the bankruptcy risk of the owner. "These are the particular reasons, in leasing at least, why SPEs are used," the source said. "To protect different classes of investors against different types of risk that can surface in conjunction with the transaction - not necessarily to achieve accounting results."

This argument hasn't fallen on deaf ears at FASB. Under the board's proposed consolidation interpretation, the SPEs behind most synthetics would have been consolidated onto the balance sheets of lessees, who assume the first risk of loss in such transactions - a potentially nasty surprise for the company's investors.

But the board has since considered making an exception for SPEs that are consolidated onto the books of a "substantive operating entity." As the SPEs often involved in synthetic leases are owned by the leasing companies or banks and consolidated onto their balance sheets, not the lessee's balance sheet, they could be immune from the interpretation.

Another point of contention surrounding synthetic leases has been their typically short tenor - usually in the five-year area - relative to other forms of alternative real estate financing such as sale/leasebacks. With a short-term financing matched to a long-term asset, the risks associated with re-financings, buyouts, and residual value guarantees raise the possibility of another bitter pill for investors down the road.

Again, a source pointed out, these concerns may be a case of throwing the baby out with the bathwater. "Many, many long-term synthetic leases have been done," she noted, with terms extending, in her experience, past 20 years. The reason that synthetics have frequently been done on a five-year basis, she added, is that CFOs have enjoyed the benefits of low cost, Libor floating rate money that is reflected in a very low rent expense - a 3% floating rate, for example, compared with 7% for a 10-year financing and 10% for a conventional real estate lease.

"The refinancing risk here is no different from any other term credit facility, or notes or bonds that companies have," the source continued. "The choice between shorter and longer term really has to do with the company's overall mix of liabilities, including tenor and choice of borrowing vehicles through banks or capital markets. The only problem that exists now for refinancing is situations in which banks or other lenders aggressively extended credit to companies over the last few years in cases where they shouldn't have. This isn't a problem that's peculiar to synthetic leases."

Nonetheless, market players in the sale/leaseback dugout have been predicting a significant uptick in deal flow in their arena (see PPL 6/17/02) from companies wanting to "escape" synthetic leases.

Not so, according to the source: "I wouldn't say that there's going to be a deluge,'" she said, quoting from the PPL article. She added that any increase in sale/leaseback deal flow would come primarily from companies that have either made a strong determination not to own real estate, or simply cannot access capital through other capital markets instruments.

"Everyone else is either going to keep the financing in place - even if the lease were to have to be consolidated - or just use their credit lines, bonds, so forth to pay it off. Off balance sheet treatment is not what's driving them. I do not expect a major shift into sale/leasebacks."

Late last month, discount retailer Dollar General completed a $450 million revolving credit facility, some of the proceeds of which will be used to pay down debt associated with synthetic leases that supported approximately 400 stores. In early May, Cisco announced that it would pay $1.9 billion to buy properties the company had previously leased using synthetics.

Satisfaction guaranteed?

Another FASB issue that will affect synthetic leases - as well as myriad other financial instruments - is the Board's project involving a guarantor's accounting and disclosure requirements for guarantees.

Leases contain guarantees for general purposes, such as when a lessee indemnifies a lessor against the liabilities and risk associated with, for example, an aircraft, as well for tax purposes.

According to a FASB release, the proposed interpretation would clarify and expand on existing disclosure requirements for guarantees, including loan guarantees. It also would require that at the time a company issues a guarantee, the company must recognize a liability for the fair value, or market value, of its obligations under that guarantee.

The disclosure element of the interpretation - requiring the disclosure of the nature and maximum amount of a guarantee or obligation - has so far met with little resistance among real estate investment banking players, some of whom have suggested that FASB should mimic what the Securities & Exchange Commission has done in that arena.

The recognition component of the interpretation, however, which requires companies to measure and recognize the fair value of the guarantee on balance sheet, has raised some objections. The rub reportedly lies in FASB's lack of guidance as to how one measures fair value, as well as the fact that the interpretation deals only with initial recognition, not subsequent recognition and the consequent effect of this liability on a company's balance sheet.

"It's very difficult to value a guarantee," said a market source. "We can all guess, based on accounting practices, what the subsequent effect would be, but FASB has limited the scope of this project to initial measurement. The Board is asking us to measure one part of a contract and not another - they're only getting half of the picture."

Going forward

As FASB approaches the endgame in both its SPE Consolidation and Guarantee projects, capital markets players are beginning to gain a clearer picture of the new proposed landscape. And whether or not synthetic leases go the way of the dinosaur or simply the cealocanth, the general demand for synthetics by corporations has declined, reportedly due to issues with the public perception of off balance sheet financing. "Krispy Kreme was the poster child for that," the source commented.

Krispy Kreme Doughnuts Inc. considered using a synthetic lease earlier this year to finance a new $35 million mixing plant and warehouse in Illinois. Investor concerns over disclosure ultimately forced the company to back away from its plans and pursue a traditional mortgage instead.

There are deals getting done, according to sources, but primarily smaller and lower-profile transactions. For example, Fitch Ratings recently affirmed an A-' rating for $44 million in outstanding securities from a synthetic lease transaction involving the Parma Community General Hospital in Parma, Ohio. Separately, Michigan-based utility Consumer's Energy completed a $79 million synthetic lease offering last March through lead agent FleetBoston Financial, sources said.

Nevertheless, many companies have elected not to do synthetics in cases where the accounting treatment was "a nice-to-have, but not a need-to-have" feature, and many companies have simply delayed decisions on synthetic leases pending the outcome of decisions at FASB.

As far as existing synthetic leases, very few, according to a market source, have been paid off. "I believe that the financing is still attractive for most companies and they would keep the financing in place even if they were forced to put the financing on balance sheet," she continued.

"At the end of the day, this is the big decision that a company has to make - does the financing make sense for them with regard to rate and term? Balance sheet issues will be secondary."

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