Phorgy Phynance

SFAS 140

with 6 comments

Over on NP, rowdyroddypiper, a.k.a. rrp, on July 26 said:

If you want to see what goes into getting something off balance sheet start reading up on FAS 140. I will send you something if you like on it.

I consider this homework that I haven’t done yet, but thought it was interesting to see FAS 140 appear on one of my favorite blogs, Calculated Risk

SFAS 140: Like A Bridge Over Troubled Bong Water

Physicists often shoot from the hip and go with what feels right. This is a bit more serious than it may sound because you spend years and years of hard core technical training to be able to discern real content from BS. A lot of that thought process becomes subconscious so I’ve learned to trust my gut over time. Another “gut” feeling is that SFAS 140 will come more and more into play as the credit cycle turns. Particularly as default rates increase. Corporate balance sheets appear to be strong and that has been one justification for tight spreads over the past couple of years. I think we’ll discover that the appearance of strong balance sheets will turn out to be little more than smoke and mirrors as default rates increase. Understanding what off-balance sheets exposures to a turn in the credit cycle corporations have will be crucial for investors in the next few months I think.

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Written by Eric

August 6, 2007 at 12:00 pm

6 Responses

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  1. Phorgzilla, the reason I recommended that you read up on FAS140 is because I do in fact know what I am doing. Read the post carefully from the link. I agree with them 100%. FASB interpretations are not going to be re-thought in order to put everything on balance sheet, simply because servicers are exercising a little more flexibility than they baked in. I can tell you that I have seen changes to FASB that are going to take 5-7 years to implement. Unlike the media it’s not kneejerk.

    If you want to look at a ludicrous example of what putting things on balance sheet will do for you, I can give you one.

    B-Piece buyers in CMBS transactions generally acquire the bottom 3% of the transaction. They also generally retain the special servicing rights. Special servicer is who gets called when the planes don’t land properly and some borrower doesn’t pay up.

    Now assuming that the pool is 1Bn, the B-Piece guy has a 30MM face amount of investment. Given the coupon is generally well inside yield, the B-piece goes for a $.60 px. That’s a 18MM investment for the buyer. Now if CMBS is not deemed to be a Q, there is the likelyhood that the B-Piece investor will have to consolidate the whole capital structure onto the balance sheet. That means that rather than putting 18MM of assets on the balance sheet for the transaction, whatever leverage they have on their investment (maybe 50%) and the resulting equity (50%) resulting in 9MM of debt and 9MM of equity the entity will put on 1Bn of Assets, 991MM of debt and 9MM of equity. Not only does this balloon the assets and the liabilities substantially it will balloon income and expenses by similar proportion. This when the investor has no more exposure to the transaction than his initial 18MM investment.

    Now, I have heard the argument that putting this on balance sheet shows the whole leverage of the transaction. This may be true, but an investor that does not know owning first loss positions in securitized vehicles is a levered investment may have the wrong investment. The inclusion of a bunch of assets and liabilities and income and expenses that are not the responsibility of the company doesn’t serve to clarify the company’s position it serves to make it murkier. Just my 2bps.

    RowdyRoddyPiper

    August 6, 2007 at 5:54 pm

  2. Thanks for your comment rrp dude. You just raised the quality of content on this blog by at least an order of magnitude. I took your advice to look at FAS 140 seriously precisely because I know you know what you’re talking about and truly appreciate any pointers and other words of wisdom.

    You made the suggestion to check out FAS 140 on July 26. On July 27 I was packing and on July 28 was on a plane to HK. We just got back and I’m almost jet lag free and FAS 140 is definitely on the to-do list. I haven’t even been able to read that link closely yet, but definitely plan to.

    Some of my old colleagues were accounting research analysts and a big theme they talked about was “fair value accounting”. Not sure if it is directly related, but it seems there are enough accounting changes in the pipeline that it’d be wise to be up on them.

    What you say about FAS 140 and particularly securitized mortgage products makes perfect sense. I don’t disagree, but my thinking is that there is something else less obvious related to FAS 140 (or at least off-balance sheet exposures) that will crop up once default rates pickup again. We’ll see. Like I said, I don’t have anything more to support the idea than basic human greed on the part of corporate executives during a period of easy credit.

    Cheers!

    phorgyphynance

    August 6, 2007 at 8:28 pm

  3. […] overload after just getting back from a too-short visit to HK. In response rrp dude’s comment on SFAS 140, I mentioned that some of my old colleagues talked quite a bit about the impending introduction of […]

  4. Eric, dood,

    if you look for exposure that suddenly pops up when things go bad simply take backup/liquidity credit lines. These are typically used together with SPVs where the originating bank acts as a lender of last resort. Similar games among corporates, they take big committments from the banks, pay close to nothing and go to the rating agencies and say “See, we got xxx bn USD backup liquidity, so we can always redeem our bonds at par, thus we should keep our rating.”

    It is really nothing more than that and honestly, I have no clue how these things are treated accounting-wise. But the sheer size of these guarantees makes me shiver. And this is no structured finance mumbo-jumbo but good ol’-fashioned lending business. Just my 2 bps.

    Cheng

    August 7, 2007 at 6:24 am

  5. Hmmm… interesting. Thanks for your comment Cheng. RRP’s comments increased the value of the content here by an order of magnitude and you’ve increased it similarly 🙂

    Regardless of what RRP says, I don’t think “Structured Finance = Bad”. If I did, I wouldn’t be starting a new job next week in structured finance 😉 This undefined concern I have about off balance sheet corporate exposure during a downturn in the credit cycle is not necessarily confined to structured finance.

    Thanks for the pointer to backup/liquidity credit lines. That sounds like a likely culprit for what I’m looking for. Now I (we?) need to think of the likely consequences since I do think the credit cycle is turning (has turned?) and something like this could turn things ugly once default rates revert back to normal levels (and maybe beyond).

    phorgyphynance

    August 7, 2007 at 8:00 am

  6. I think this won’t be a real issue unless we see mass defaults among conduits (similar to IKB’s Rhineland Funding) plus mass defaults among IG issuers at the same time. And even then banks might recall the credit lines as Deutsche did in the case of Rhineland Funding. There is a veeeeeeeery remote potential for a nasty liquidity crunch but I keep my fingers crossed that this won’t happen (if it would we were in extremely deep shit).

    Cheng

    August 8, 2007 at 12:30 am


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