One commonality linking two of the biggest financial disasters of the current decade - the collapse of Houston-based energy firm Enron in 2001 and the ongoing credit crisis - is the presence of off-balance-sheet entities. It is not altogether unsurprising, then, that politicians on both sides of the Atlantic have linked the two events and demanded urgent action.
"After Enron, with Sarbanes-Oxley, we tried legislatively to make it clear there has to be some transparency with regard to off-balance-sheet entities," wrote Jack Reed, the Democratic senator for Rhode Island, in a letter to the US Securities and Exchange Commission (SEC) in February. "We thought that was already corrected and the rules were clear and we would not be discovering new things every day."
Meanwhile, in the UK, the Treasury has asked the Financial Services Authority (FSA) to "consider whether banks have been using these off-balance-sheet vehicles for genuine economic efficiency reasons or as a smokescreen to hide behind, given that the capital reporting and governance requirements on these vehicles are lighter than those incumbent on banks themselves".
Given that the current crisis could result in anywhere between $200 billion and $400 billion of losses, bankers concede it would be foolhardy for regulators not to conduct a thorough examination of the effect off-balance-sheet vehicles have had on recent events. Nevertheless, it is important to recognise that the role these vehicles played in the Enron scandal was fundamentally different to how they were used in the run-up to the subprime crisis.
Enron exploited loopholes in accounting rules to use special-purpose vehicles (SPVs) specifically to hide losses. In the latest crisis, banks used asset-backed commercial paper (ABCP) conduits and structured investment vehicles (SIVs) to increase leverage to certain assets, including subprime mortgages. This strategy helped boost profits during benign credit market conditions, but when the bottom fell out of the subprime business in the second half of 2007 - and with it, the value of securities linked to the sector - losses began to mount at several European and US houses.
Political hysteria notwithstanding, even respected figures within the financial industry say the current situation has brought to light serious issues. A primary benefit of SPVs is to allow originators to redistribute risk - the so-called originate-and-distribute model. By transferring assets from their balance sheets to an SPV, packaging them up and selling them on to investors, banks are able to free their balance sheets and originate more loans.
However, financial institutions also used off-balance-sheet vehicles to arbitrage differences between short-term and long-term funding costs. Bank conduits and SIVs would raise cheap financing in the short-term ABCP market and invest in higher-yielding, long-dated assets such as collateralised debt obligations (CDOs) and residential mortgage-backed securities, enabling them to generate returns.
Parent banks agreed to provide liquidity facilities to ABCP conduits in the event their short-term funding could not be rolled over. These commitments came back to bite them when ABCP investors fled and rising delinquencies in the US subprime mortgage market caused CDO prices to plunge, meaning conduits were unable to repay short-term liabilities falling due. Several banks were forced to consolidate vehicles on to their balance sheets - a scenario most had not considered nor set aside capital for.
"A major cause of the strains in credit and funding markets has been the apparent inability of many firms to anticipate the interaction of their various on- and off-balance-sheet exposures and, particularly, to understand the velocity of their off-balance-sheet activities and how these affected their overall exposures," says Peter Fisher, New York-based co-head of fixed income at investment management company BlackRock, and a former undersecretary of the US Treasury.
Some argue the problem was caused less by the vehicles themselves than the complexity of the assets. Specifically, some assets securitised were overly complex - for instance, CDOs of asset-backed securities (ABSs).
"It is important to distinguish between the vehicles and the structured finance instruments - the risks are not identical," says a senior official at a regulator. "Banks should still be able to redistribute risk through simple securitisations, but some structures - such as CDOs of ABSs - have the potential to transform risk in ways that are non-linear. So while the calls to ban these vehicles are kneejerk, there is validity in the argument that the use of these vehicles has been taken too far."
Likewise, many conduits and SIVs had invested in difficult-to-value and illiquid instruments such as CDOs of ABSs to bolster returns. When ABCP investors refused to roll over short-term funding from August, vehicles were left holding on to illiquid assets in a falling market (Risk September 2007, pages 105-107).
While amendments to rules governing their usage seem inevitable, early indications suggest a wholesale ban on off-balance-sheet vehicles is unlikely. The FSA, for instance, is looking at off-balance-sheet vehicles to see how they influenced the turmoil in the markets. However, Stephen Condon, technical specialist within the structured finance risk review group at the FSA, says it is doubtful the supervisor will prohibit their use.
"Calls for the complete banning of these vehicles would be a kneejerk reaction. Our role as a regulator is not to take a blinkered view, but to try to look at events in context to understand the causes and implications. It has to be remembered these structures do have several good qualities as long as the risks are understood," he notes.
Meanwhile, in the US, the President's Working Group on Financial Markets (PWG), which comprises representatives from the US Treasury, Federal Reserve, the SEC and the Commodity Futures Trading Commission, released a report in March detailing specific failures by financial institutions in the run-up to the subprime crisis. These include a breakdown in underwriting standards for subprime mortgages and an erosion of market discipline.
"There were serious weaknesses in risk management at several large US and European institutions, especially with respect to the concentration of risks, the valuation of illiquid instruments, the pricing of contingent liquidity facilities and the management of liquidity," states the PWG.
Additionally, the group notes existing capital requirements encouraged securitisation of assets through facilities with low capital requirements, and failed to provide adequate incentives for firms to maintain sufficient capital and liquidity buffers. "Further, supervisory authorities did not insist on appropriate disclosures of firms' potential exposure to off-balance-sheet vehicles," the group adds.
The Senior Supervisors Group, a body of regulators from France, Germany, Switzerland, the UK and the US, raised similar points. In its March 6 report, the group noted that some firms failed to properly price the risk that exposures to certain off-balance-sheet vehicles might need to be funded on balance sheet, at exactly the time it would be most difficult and expensive to raise funds externally.
Some firms did not properly recognise or control contingent risk in conduit businesses or recognise reputational risks associated with SIVs, the group added. For that reason, some banks that set up or sponsored SIVs, including Citi and HSBC, felt compelled to bring SIV assets back on balance sheet at significant cost rather than restructure or wind down the vehicles, even though they were not legally required to do so (Risk December 2007, pages 75-77).
Even so, the PWG and the Senior Supervisors Group refrained from calling for immediate policy changes. Instead, they pointed to general issues that need to be addressed, both by regulators and banks.
The PWG, for example, advises banks to improve information systems to ensure aggregation of exposures across all business lines and rigorous valuations of instruments and exposures. Incentives should also be in place for financial institutions to hold capital and liquidity cushions commensurate with firm-wide exposures (both on and off balance sheet) to severe adverse market events. "These cushions should be forward looking and adjust appropriately through peaks and valleys of the credit cycle," the PWG stated.
This draws some observers to expect that banks will be required to hold more capital against off-balance-sheet exposures at some stage. Currently, treatment of off-balance-sheet vehicles in the US - also known stateside as variable-interest entities (VIEs) - is governed by the accounting rule FIN 46R, set out by the Financial Accounting Standards Board. Under FIN 46R, the holder of the majority of risks (expected losses) and rewards is deemed the primary beneficiary of VIEs, and is therefore required to consolidate the assets on its balance sheet.
However, US bank sponsors of SIVs and ABCP conduits were, until recently, able to avoid this if they could sell the first loss piece to outside investors. In fact, it was the potential damage to reputations in the wake of declining asset values and the risk of wind-downs that caused some banks to consolidate off-balance-sheet vehicles, not a legal requirement.
Most other countries, however, base their interpretation of what constitutes off-balance-sheet treatment under a variety of International Financial Reporting Standards set out by the International Accounting Standards Board. Under IAS 27 and IAS 39, companies have to consolidate an off-balance-sheet vehicle if they are assumed to have control of the vehicle and if they bear the majority of risks and benefits. Essentially, for an originator to derecognise assets transferred to a vehicle, it has to prove conclusively it has not retained substantially all the risks and rewards.
"The regulatory change, when it comes, will possibly try to factor in the possibility of extreme stress events because that is what causes big problems, not normal conditions," says Mike Lloyd, London-based partner in charge of Deloitte's treasury and capital markets group. "The only outcome of that for the financial services industry would be a big increase in capital. That is the only way, along with de-leveraging the balance sheet, banks could survive an extreme stress event."
Meanwhile, the PWG called on the Basel Committee on Banking Supervision to review capital requirements for CDOs of ABSs and other re-securitisations, with a view to increasing requirements on exposures that have caused losses. This was echoed by the Supervisory Group's review, which supported a strengthening of the Basel II framework, including the setting of high standards for what constitutes risk transfer, increased capital charges for certain securitised assets and ACBP facilities, and sufficient scope for addressing implicit support and reputational risks.
Under Basel I, banks were able to hold zero reserves against off-balance-sheet items. However, any contractual exposure to SIVs and conduits is subject to regulatory capital rules under Basel II, regardless of the accounting treatment. The framework also requires banks to stress-test on- and off-balance-sheet exposures, and prove to supervisors they have adequate capital reserves to manage through a down cycle.
Despite political cries for banks to return to the originate-to-hold model and keep all assets on balance sheet, this was not advocated by the PWG or Senior Supervisors Group. While such a philosophy would almost certainly have prevented the recent subprime debacle, it does not take into account the contribution to economic growth off- and on-balance-sheet securitisation vehicles have had.
"If banks had used an originate-to-hold model, the damage would have been limited because there is full alignment between the originator and holder of the assets, which should lead to better underwriting standards," says Serge Gwynne, partner at Oliver Wyman in London. "But if you have to hold assets on balance sheet, it constrains the volume of business you can do. This would have prevented the boom in credit, but at the same time it would have slowed growth."
A return to originate-and-hold would be a step backwards, and would restrict the access of certain segments to the capital markets, adds David Rowe, London-based executive vice-president of risk management at SunGard. "The originate-and-distribute approach has allowed for a much broader range of potential investors to participate in markets that used to be closed, which quite frankly meant the costs for the people borrowing were higher," he argues.
Most practitioners insist the issue has more to do with banks over-leveraging themselves through the vehicles. Given the scale of recent losses, banks are unlikely to make that mistake again any time soon, regardless of rule amendments.
"Off-balance-sheet vehicles in general will go through a very difficult period over the next couple of years," says Douglas Long, London-based executive vice-president of business strategy at Principia Partners, a provider of software solutions for the management of structured finance operations. "Even as the market levels out and liquidity returns, I would expect less leverage and simpler structures. For banks with more assets on balance sheet, there will be an increased push to securitise products through a single, consistent portfolio, which will make it easier for them to look at and manage overall exposures in a consolidated way."
One likely change is that banks will take more responsibility for assessing off-balance-sheet risk to determine if it could have a material impact on their balance sheet. "The key for any business that actively uses these vehicles is looking at risk holistically and being able to measure and quantify the impact of off-balance-sheet items on their net risk profile. For example, if the balance sheet leverage is 15:1, but the use of off-balance-sheet items brings the effective leverage up to 40:1, a company should know this," says James Lam, Boston-based president of risk management consultancy James Lam & Associates.
While many participants stress the positives of banks moving risk off balance sheet, the consensus view is that a return to simplicity - both in terms of securitised assets and vehicles - would be a logical approach for banks to take. "Ultimately, certain CDO products were overly complicated and, in some cases, poor-quality assets were dressed up as something else," says Barrie Wilkinson, London-based partner at Oliver Wyman. "Investors will also be sceptical about investing in highly leveraged vehicles going forward, particularly if they run liquidity risk. The concept of taking high-quality five-year or 10-year assets and leveraging them 30 times, and then funding it with one-month paper was an extreme bet."
Looking forward, regulators will want better and more timely information on the assets transferred to off-balance-sheet vehicles. However, some argue much of this information has always been available - if investors are willing to search for it.
"The initial focus has to be on the information flowing from originators through asset structures, so investors are better aware of what they are buying," asserts BlackRock's Fisher. "However, it must be said there is more information out there, beyond the ratings, than investors are prepared to admit. They have to be able to break deals down, see what assets are in the pools and take a view on whether the cashflows are worth the risk. There is a lot of dirty fingernail work."
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