Off-Balance-Sheet
and financial engineering...
from the
International Association of Risk and Compliance Professionals
(IARCP)
The
"structured" world
Structured
financial markets. Structured financial products. Structured
financial planning. Structured financial solutions. Structured
financial analysts. Structured financial instruments. Structured
financial vehicles.
What do you mean "Off-Balance-Sheet"?
An asset or a liability that is not on your company's balance sheet.
It can be something simple, like a letter of credit (an
obligation). Or something very complex. Your imagination is the
limit.
So it is not on our company's balance sheet. Where is it?
Perhaps on the balance sheet of another company.
Usually
on the balance sheet of a Special Purpose Entity (SPE).
Your company's shareholders perhaps know it, perhaps not.
Tell me more about these SPEs
An SPE can be a trust or a company. I told you - only your
imagination is the limit. I like some exotic descriptions like
Special Purpose Corporations (SPCs), Special Purpose Subsidiaries,
Master Trusts, Grantor Trusts, Real Estate Mortgage Investment
Conduits (REMICs), Financial Asset Securitization Investment Trust
(FASIT) or Domestically Domiciled Corporations.
A good
SPE must be
"bankruptcy remote"
so that the bankruptcy of the originator does not affect the SPE's
assets.
A good
SPE structure must meet the requirements for
off-balance sheet treatment
of
the assets, so that the assets will not be consolidated on the
originator’s balance
sheet for accounting purposes.
Is it bad?
Not necessarily. There are good and bad reasons to use SPEs.
I have to
confess that I like Special Purpose Entities. So you need to
discuss the same issues with other persons, there are definitely
different opinions.
For me, a SPE
is like a knife. You can use your knife to butter your bread
or to kill someone.
Which are the good reasons to have SPEs?
They are great "structured risk management solutions".
For example, you want to finance a new business or a new big project. But, the
shareholders of your company do not want to take the business risk.
What can you do?
You can form a SPE.
It
is an "off-balance-sheet entity" because you transfer the risk from
your company to the new entity, so no liability will appear on your
balance sheet.
We call it a
"special purpose"
entity, simply because it has a special purpose: To house the new
business. Perhaps there are other shareholders (the shareholders of
the SPE) that do want to
take the
business risk of this business.
Can you give me another example?
Sure. Our company
needs financing for a new business. Unfortunately, our company is
not such an attractive client for the banks, as there is debt on our
balance sheet. Some banks could agree to finance out new business,
but the interest rate would be high to reflect the increased risk.
What can we do? We can
set up a special-purpose entity. We sell an asset to the SPE, and
the SPE can pay our company from the profits of the management of
the asset. Or, our company offers to guarantee a loan for the SPE.
(Disclose it to your shareholders! Enron guaranteed some of its SPEs
debt with its own shares but did not bother to explain). Now the SPE
has an asset, and no debt and liabilities. It is the perfect client
for some banks. The interest rate will be low. Shareholders are
ready to invest.
If we create a SPE, it
is another company,
with
its own risk-reward characteristics. It can establish its own lines
of credit. The SPE can have a better rating, perhaps AAA- even if
our company is rated BBB- and a
lower cost of funding.
It is good!
I can not see why some people say that it is bad!
If you hide obligations from your
shareholders, it is very bad.
Yes, if assets and liabilities
are not placed on your company's balance sheet, they don't have to
be matched, it looks great, but... Disclosure is the real
differentiator here: If you tell the truth to the markets, it is
good. If you mislead and misrepresent your company's financial
condition, it is bad.
For example, Enron
crated many SPEs and used them to hide billions of dollars in debt.
Enron's SPEs were created strictly for the benefit of the top
management, not the shareholders.
Some old
friends
from the accounting still believe that SPEs
are
"balance sheet management solutions". After Sarbanes-Oxley
they must forget some tricks of the trade.
I have read something about that - do you mean
"creative accounting"?
I prefer to call it "financial engineering". Before Sarbanes Oxley, it was
difficult to persuade large companies NOT to use special purpose
entities. Now things are different. We must disclose what we do.
I have also read that Wall Street is the
reason for SPEs. Is it possible?
Not
directly... yes it is a reason.
Companies
are always trying to
reach high targets to impress the Wall Street. Compensation plans
are based on the same targets.
If you can not sell more services or
products, you may think to establish a SPE and sell to your SPE. You
are the seller and the buyer. You sit at both sides of the
table when you "sell", so you reach your targets... (like
Enron)
Sometimes you
write something about that in the footnotes to the financials, but
is has become an "art" to use the proper words to
hide something by
disclosing it.
Sometimes CEOs like to show a really good net number on the balance sheet and
to leave all the details in the footnotes. They know that many
investors will never be able to learn the details.
What about
Sarbanes-Oxley and Off-Balance-Sheet?
What about
Basel ii and Off-Balance-Sheet?
|
