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If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It? Pt 4 - Wells Fargo

Submitted by Reggie Middleton on 10/19/2009 05:46 -0400

Before I delve into specifically what makes Wells Fargo an ongoing
Doo Doo list member, I urge those who do no normally follow me to read
the precursors to this article:

After reading through Wells Fargo's numbers below, I want some of you
guys (and gals) with calculators and spreadsheets to review "I'm going to try not to say I told you so..."
and let me know the chances of the FDIC's absorbing a behemoth such as
the CDO trading, CDS writing, off balance sheet VIE having, QSPE
bulging, California and Florida Zero recovery 2nd lien sporting Wells
Fargo in the case some of its arcane and non-performing assets really
hit the fan. I am getting ahead of myself though. Let's take this from
the beginning.

When the ticker WFC came up as a short list finalist in one of our
scans last year, I was able to hear the cackling of those name brand
groupies and CNBC junkies literally leaping from my keyboard. This is
an excerpt from a free piece that I released on them exactly a year and
a half ago, before the days of TARP:

"Well, the
first bank on the drill down list will also be 2nd of the banks that I
will deliver a forensic analysis on (the first was PNC Bank).
That bank is,,, (drum roll in the background, crescendo.... I know some
of you hate it when I do this........) Wells Fargo! I can hear a few of
you naysayers cackling behind your computer screens as I type this.
Wells Fargo is a big name brand bank (cackle, cackle)! Wells Fargo has
Warren Buffet as its largest investor (cackle, cackle)! Wells Fargo
this and that and blah, blah and (cackle, cackle).... All I can say is,
beware of name brands (I actually felt compelled to address this in earlier posts).
I have made more than a couple of dollars benefiting from name brand
hubris and smaller investors who would rather be told what to do than
read a balance sheet! Time will tell if I am right or not on Wells
Fargo, just be forewarned - several of the banks on the Doo-Doo 32 (32 banks in deep doo-doo) list have already taken a trip to the confessional!"

Well, fast forward a year and a half and we see who was right. I urge those who do not subscribe to my blog to reference "Doo-Doo bank drill down, part 1 - Wells Fargo". Wells Fargo was actually one of the original Doo Doo 32 banks (32 banks in deep doo-doo),
a list of institutions quite likely to hit the fan from an investor's
perspective. I welcome all to track the well being of the banks on that
list from that period to date. As for Wells Fargo, even despite extreme
efforts by the government to prop it up, it appears as if I was on to
something back then. Although many pundits STILL believe that I am
wrong, the more I dig into the innards of this bank, the more cracks I
see in its armor.

The risks posed by the housing crisis and arcane financing vehicles are drastically under-appreciated by the sell side...

Wells
Fargo's high risk from its exposure to some of the hardest hit regions
like California and Florida was further enlarged through the
acquisition of Wachovia's ailing portfolio. The surge in NPAs pushed up
the Texas ratio of the Bank to 29.9% as of June 2009 from
19.1% in December, 2008. Wells Fargo Eyles Test exceeded the allowance
for loan losses by $3.7 billion or 6.3% of the tangible equity as of
June 30, 2009 as against the excess allowance for loan losses over ET
of $3.4 billion or 7.5% of the tangible equity in Dec 2008. As the rise
in NPAs is far from subsiding, the Bank is expected to feel additional
the pressure from high charge offs and provisions (see the latest news on the housing front and proposed FDIC charges whose charges have already [within a month] seen the need to be modified, see "I'm going to try not to say I told you so...").

Further,
Wells Fargo acquired Wachovia's impaired loan portfolio valued at $56
billion (as of June 2009) at a discount of 36.2% from principal balance
outstanding. These loans are classified as SOP 03-3 loans and are not
included in the non performing category since they were acquired at
substantial discount and the bank expects to recover the fair value.
Consequently, the related provisions for loan losses and charge offs on
these loans are very low. However, Wells Fargo runs the risk of further
deterioration in this portfolio which will necessitate increase in
charge offs and provisions for these loans. This has been the case with
JP Morgan's highly discounted purchase of WaMu's troubled loan
portfolio, which is already in the negative only midway or so in the
housing cycle decline, despite aggressive discounting. See:

Write
downs on investment securities along with other assets like MSR
(Mortgage servicing rights) and mortgages held for sale will further
erode the shareholder's wealth.

Wells
Fargo carries about $43 billion of highly vulnerable privately issued
mortgage backed securities (both RMBS and CMBS), out of which $34
billion are level 2 assets and $9 billion are level 3 assets (highly
illiquid). Further, the Bank carries about $28 billion of other debt
based assets consisting of asset backed securities collateralized by
auto leases, corporate debt and collaterized debt obligations. Out of
$28 billion, about $19 billion are level 3 assets while the remaining
are level 2 assets. While the Bank values the level 2 assets using the
relative value of similar securities or assets in the market, the fair
valuation of level 3 assets is completely based on valuation models
built through management's own assumptions and outlook. Based on credit
losses likely to be realized on these mortgage and asset backed
securities, we expect significant write downs. Additionally, Wells
Fargo carries $16 billion of MSR (Mortgage servicing rights or the
retained interests in its loan securitization arrangements) and $40
billion of mortgages held for sale. While MSR completely falls under
level 3 assets category, of the $40 billion of mortgages held for sale,
about $4 billion are level 3 assets while the remaining are level 2
assets. We expect additional write downs on these assets as well.

We
expect total write downs of about $11.0 billion till 2010 under our
base case which amounts to about 19.0% of the tangible equity as of
June 30, 2009.

Risk emanating from the massive derivative exposure.

Wells
Fargo's huge derivative exposure further adds to the credit risk of
Wells Fargo. The notional value of the derivative contracts of Wells
Fargo as of June 30, 2009 was $3.7 trillion and the bank is exposed to
the counterparty risk emanating from these contracts. As of June 30,
2009, the notional value of the credit protection sold was $105 billion
with the fair value of these contracts pegged at $14 billion (carried
in the balance sheet). Out of this credit protection sold, about $46
billion of the contracts have underlying entities of below investment
grade and have high risk of default. To hedge the credit risk, the bank
has purchased credit protection on identical underlying entities of $34
billion (notional value) along with $74 billion of other credit
protection purchased. Just in case the point has been lost amidst all
of these words - it appears as if Wells Fargo is doing the AIG thing as
well. Maybe not to the extent of AIG or even Bank of America, but they
are not adequately protected from my perspective. This is even more
telling, for this activity is corroborated by reports from the grass
roots level. See Wells Fargo's Ticking Time Bomb: Credit Default Swaps On ...:

It appears that Wachovia wrote credit default swaps on the junior tranches of commercial mortgage

backed securities it was selling, which means that it is on the hook
for losses in the riskiest CMBS tranches it sold. Wells itself might
not even know the size of its exposure, Buhl reports.
From Buhl:

According to sources currently working out these loans at Wells Fargo
when selling tranches of commercial mortgage-backed securities below
the super senior tranche, Wachovia promised to pay the buyer’s risk
premium by writing credit default swap contracts against these
subordinate bonds. Should the junior tranches eventually default, then
the bank is on the hook. Dan Alpert of Westwood Capital says these were
practices that he saw going on in the market at large.

Alpert says in reference to how he saw CMBS trades get done, “These
guys would say ‘We’ll just take back that silly credit risk you’re
worried about.’ Of course that was a nice increase to earnings when
they got the security sold. The bank made money at the time.”

Buhl points out that investors
might be caught off-guard if Wells has to start paying out on the swaps
it sold. Wells, like most banks, almost certainly holds the credit
default swap liabilities off balance sheet and most likely does not
recognize them as a loss until they actually have to pay, Buhl writes.
Wells says it carefully monitors its derivatives exposure. "We have
provided extensive transparent disclosures on our derivatives in our
2008 annual report beginning on page 132,” Wells says...

But it seems fair to wonder if Wells really understood all of the
derivatives exposure it took on when it acquired Wachovia. Buhl wonders
if Wells really has enough capital set aside to handle the derivatives
liability.

…So could Wells
really have enough capital to handle the liability of credit
derivatives that will likely come due within the year? As we watch more
and more of the junior tranches of commercial mortgage back securities
Wachovia sold become worthless, how will Wells Fargo afford to pay for
the risk premiums Wachovia promised they’d cover of if the loans blew
up? From all indications, the bank cannot meet these obligations
unless it raises more capital, sells good assets for a loss, or puts
more of that TARP money to use instead of sending it back to taxpayers,
as CEO John Stumpf has promised. So much for “earning our way out” of
the financial crisis.

The losses from the credit default swaps might hit even earlier than Buhl expects.

One of the lessons from AIG is that a company can be brought down by
collateral demands even before the swaps are triggered by defaults. If
the buyers of the swaps have the right to demand additional collateral
as CMBS tranches are downgraded--a very likely scenario--Wells could
find itself having to scramble for liquidity even though the underlying
credits haven't yet triggered the credit default swap payments. This,
recall, is exactly what killed AIG.

I
looked into this and Wells Fargo is indeed exposed to the risk of
credit losses from the credit protection sold as well as the risk of
collateral calls from the Credit Default Swaps, particularly those
written under the Wachovia securitizations.

Assuming
the unhedged proportion for the non-investment grade portfolio to be
same as the unhedged proportion of the overall portfolio, we expect to
see collateral calls. See our subscription content ( WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb) for what we see and how much under base, optimistic and pessimistic cases over the next 4 years.

Wells Fargo and What May Lie Off Balance Sheet

Wells
Fargo uses Special Purpose Entities (SPE) for various securitization
activities wherein financial assets are transferred to an SPE and
repackaged as securities and sold to investors. As of June 30, 2009 the
carrying value of Qualified SPE's (QSPE) in the company's balance sheet
stood at $37 bn (64% of tangible equity) while carrying value of
unconsolidated variable interest entity (VIE) and consolidated VIE
exposure stood at $4 bn and $1.8 bn, respectively. In aggregate,
carrying value emulating from QSPE and VIE exposure stood at $80 bn, or
137% of tangible equity as of June 30, 2009. It should be noted that
WFC's acquisition of Wachovia brought with it a brokerage arm, not to
mention a bevy of poorly performing assets. True commercial banks with
investment, trading and brokerage arms are ones that I look to to have
hidden skeleton's in the closets in the form of off balance sheet
liabilities and hidden contingencies. Wells Fargo has apparently not
proven me wrong.

Transactions with QSPEs

Wells
Fargo uses QSPEs to securitize consumer and commercial real estate
loans and other types of financial assets, including student loans,
auto loans and municipal bonds. The Company typically retains the
servicing rights from these sales and may continue to hold other
beneficial interests in QSPEs. Through these securitizations the
company may also be exposed to liability under limited amounts of
recourse as well as standard representations and warranties made to
purchasers and issuers. As of June 30, 2009 Wells Fargo
had carrying value of $37 bn from its QSPEs transaction while maximum
loss exposure stood at $43 bn, or 74% of tangible equity. Maximum
loss exposure from debt and equity interest, and servicing assets was
at $21.6 bn and $15.9 bn, respectively. Maximum loss exposure is
defined as the carrying value of off-balance sheet QSPEs exposure plus
remaining undrawn liquidity and lending commitments, notional amount of
net written derivative contracts, and notional amount of other
commitments and guarantees.

As
of June 30, 2009 Wells Fargo's reported loan exposure was at $821 bn.
In addition, the company had securitized loans of $1,169 bn and held
for sale of $47 bn. Total loans owned and securitized by Wells Fargo
was $2,038 bn as of June 30, 2009 while delinquent loan exposure was at
$29.6 bn, or 50.6% of tangible equity.

Transactions with VIEs

Transactions
with VIEs include securitization involving collateralized debt
obligations (CDOs) backed by asset-backed and commercial real estate
securities, collateralized loan obligations (CLOs) backed by corporate
loans or bonds, and other types of structured financing. Total assets
from unconsolidated vehicles as of June 30, 2009 stood at $273.4 bn
while the carrying value on firm's balance sheet was $40.5 bn. Maximum
loss exposure (as defined above) from these VIE's as of June 30, 2009
was $55.0 bn, or 94% of tangible equity - practically all of the companies available equity! Notice how you never here this on CNBC!!!

Wells Fargo also administers a multi-seller asset-backed commercial paper (ABCP) conduit (included in above VIE exposure with maximum loss exposure of $7.8 bn) which was acquired from Wachovia merger (that's right, the Wachovia merger looks to come back to haunt, again!). The
conduit makes loans to, or purchases certificated interests from SPEs
established by WFC's clients and are secured by pools of financial
assets. The conduit funds through issuance of highly rated (or so they
say) commercial paper to third party investors. The primary source of
repayment of the commercial paper is the cash flows from the conduit's
assets or the re-issuance of commercial paper upon maturity. The
conduit's assets are primarily backed by commercial loans (48%)
followed by auto loans (24%) and equipment loans (15%). The
asset quality of the conduit acquired from Wachovia can easily be
described as deplorable with 42.2% categorized as BBB and below - or
roughly half junk or borderline so.

Off Balance Sheet Asset/Liability Mismatch, Expected Loss from QSPE/VIE and Relevant Impact on Previously Calculated Valuation

Subscribers looking for my estimates of expected losses and the effects on our calculated valuations can download WFC Off Balance Sheet Exposure 2009-10-19 04:11:50 259.25 Kb as an addendum to the following subscription materials:

WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb - The complete off balance sheet review

WFC Full Forensic Analysis & Research Note 22 May 09 - Retail 2009-05-27 01:55:50 554.15 Kb

WFC
Full Forensic Analysis & Research Note with Anticipated Capital
Requirements under revised SCAP/Stress testing 22 May 09 - Professional 2009-05-27 01:56:54 853.53 Kb

I
query, why do the smaller, healthier banks continue to agree to fund
the likes of the humongous risk behemoths such as Wells Fargo, Bank of
America, et. al.? Is it a death of comparable lobbying power? If so,
simply pass this series of off balance sheet bank articles to your
local representatives AND their constituents. I am sure that can serve
to get the discussion started! See "Big Bank (and the Treasury) vs. Little Bank: Whose risking your tax dollars?" for a quick glance at the disproportionate distribution of risk.

Next
up: an update and refresher on the Market Neutral Option Strategy
Analysis that I use in conjunction with my research , a peek into my
opinion of a well known investors REIT short recommendation, and then
we snatch some more of the covers off of PNC Bank!

Related Material

The Free Stuff

The open source mortgage default model - The truth, the whole truth, and nothing but the truth

Fact, Fiction, Farce and Lies! What happened to the Bank Bears?

Beware of Bank Earnings Propaganda - They are still in BIG trouble!

Wells Fargo reports in a few hours and I wonder how forthcoming they will be with their credit losses

Wells Fargo Q2 2008 Highlights

Green Shoots are Being Fertilized by Brown Turds in the Mortgage Markets

Doo-Doo bank drill down, part 1 - Wells Fargo

Subscription Analysis - The Heavy Stuff

WFC Off Balance Sheet Exposure 2009-10-19 04:11:50 259.25 Kb - The complete off balance sheet review

WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb - The Skinny on that CDS exposure. Are they doing the AIG thing too???

WFC Full Forensic Analysis & Research Note 22 May 09 - Retail 2009-05-27 01:55:50 554.15 Kb

WFC
Full Forensic Analysis & Research Note with Anticipated Capital
Requirements under revised SCAP/Stress testing 22 May 09 - Professional 2009-05-27 01:56:54 853.53 Kb This
is the document that ties all of the ancillary research togther and
includes our best estimate as to the amount of capital Wells Fargo will
need to raise!

Wells Fargo ABS Inventory 2008-08-30 06:40:27 798.22 Kb

- advertisements -

Fri, 11/20/2009 - 06:39 | 137088 Anonymous

Hi,

What was the title of the article by Baker, Lembke, King, & Jeffrey 2009?

Thanks Charles.

Fri, 11/20/2009 - 05:29 | 137078 Anonymous

Hi,

What was the title of the article by Baker, Lembke, King, & Jeffrey 2009?

Thanks Charles.

Tue, 10/20/2009 - 15:54 | 104772 Gilgamesh

This is going to be some good comedy tomorrow, one way or the other. Look at that stock go...

Mon, 10/19/2009 - 12:16 | 103420 Anonymous

I just wanted to say THANK YOU for this, and your other related articles. This stuff is golden.

I'm just an ordinary non-financial non-accouting type who's been trying to learn more about what's really going on with the Banks, and in particular trying to decipher their financial statements. To a newbie, the public information which they publish could all be in Greek.

And add to it that there seems to be a lack of information on how to decipher it. Your postings help put me light years ahead of where I'd be without them.

I'm still trying to wrap my head around all of this, and still have a long ways to go. But even so, I find this information uniquely invaluable.

Mon, 10/19/2009 - 11:22 | 103337 Careless Whisper

Bob Steele, former Goldman Vice Chairman, took over Wachovia long enough (about 3 months) to give WellsFargo the gang rape they deserved for being stupid enough to deal with one of the boys from Goldman.

Why does it seem like every time one of their competitors fails, there's a Goldman boy lurking in the bushes?

Mon, 10/19/2009 - 12:36 | 103448 Anonymous

Because they earn their money the old-fashioned way: They steal it.

Mon, 10/19/2009 - 11:12 | 103327 Cheeky Bastard

Reggie, could you, or anyone else for that matter, tell me if the legal nature of SIVs was changed since Enron used them ? I think that is where the rabbit lays ( WTF is that even an expression, nvmd ) and why are all the banks out ( sans BAC that is ) with stellar earnings and why the market roars like a motherfucking lion on horse growth hormones.

Mon, 10/19/2009 - 12:32 | 103439 cthulhu

Nice discussion here:http://www.nysscpa.org/cpajournal/2004/704/essentials/p30.htm

Sample:

These off–balance-sheet arrangements may be called qualifying special purpose entities (QSPE) if they meet the requirements set forth in SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. Or they may be referred to as variable interest entities (VIE), in accordance with the definition and requirements established in FASB Interpretation 46 (revised December 2003), “Consolidation of Variable Interest Entities—An Interpretation of Accounting Research Bulletin (ARB) No. 51,”

SFAS 140 was released September, 2000 -- so is prior to Enron's 12/2/01 bankruptcy filing.

Mon, 10/19/2009 - 12:37 | 103450 Cheeky Bastard

thank you cthulhu

Mon, 10/19/2009 - 10:56 | 103311 GoldmanSux

Great piece!

Mon, 10/19/2009 - 10:52 | 103310 Cheeky Bastard

I'm interested in the legal nature of SIVs and why the fuck are they allowed to serve the same purpose of hiding the loses like they did when Enron ( Fastow ) used them. Basically banks are insolvent at this moment and will halt any lending until they get back on their feet via markets, depositing the money with the FED and raking up the interest rates on credit cards. And that will necessitate the inflation rate to be 10%+ in the upcoming years with a sectoral deflation in the same range. Fucking thieves, they do it so good it is almost impossible to find it out. Oh and Reggie, BAC and WFC are my next two picks for going under. Your call on that is A+.

Mon, 10/19/2009 - 13:51 | 103523 Anonymous

Take it easy with criticisms, this is a rough draft and I am currently pressed for time. Still, I had this laying around and it relates to your comment exactly. I apologize to everyone else for the length.

Introduction
This paper is a historical review of the accounting treatment for special purpose entities. It begins with their origination, and then describes their advantages or the reason for their creation. Next, the process that Enron used involving special purpose entities to hide losses is explained. Following that the new regulations for special purpose entities are described. Then, it is explained why qualifying special purpose entities were exempt from balance sheet treatment. This paper then turns to the current exposure draft affecting qualifying special purpose entities. In the end, the author argues for the treatment of special purpose entities as proposed in the current exposure draft and speculates as to when it will be effective.
The Origins of Special Purpose Entities
ARB 51 set consolidation standards when one company controls another and based control as a majority voting interest as the condition needed to consolidate. More recently many entities have been structured in a way that they are not controlled by the parent through voting interests. For these reasons ARB51 does not clearly apply to these entities, which are often referred to as special-purpose entities (SPEs). SPEs are generally defined as corporations, trusts, or partnerships created for a single purpose, usually for financing. SPEs had no clear guidance prior to 2003, but when it was discovered that SPEs were abused by Enron, which ultimately filed for bankruptcy, the need for clearer guidance was evident. More recently, SPEs have contributed to the financial crisis, and accounting for SPEs is still a very important and developing topic. (Baker, Lembke, King, & Jeffrey 2009, p. 108-109)
SPEs existing as separate entities have certain advantages for their creators. For one, many SPEs qualify to exist off balance sheet. This allows the company to operate under more leverage, potentially magnifying gains, while avoiding some capital reserve requirements or loan covenants, which may be triggered if the same financing were on the balance sheet. Since the SPE does not pay its own taxes, rather it passes through to the parent; it usually results in lower taxes. Lastly, companies often use SPEs to access the capital markets for a lower cost of capital. This is because SPEs might sell debt or equity in the capital markets directly, which bypasses traditional financial middlemen and their mark-ups, and use the capital to purchase financial instruments. Since an SPE is isolated from its parent’s bankruptcy if it were to occur, it is perceived by investors to have a lower risk than it would if the parent company were to own the financial instruments outright. Often for this reason, loan underwriters and credit ratings agencies would require the investment to be in a SPE, for example in the securitization of mortgage backed securities (MBS). For the above three reasons, which are off-balance sheet treatment, lower taxes, and financing at lower rates, SPEs can circumvent accounting treatment that would otherwise result in higher debt and decreased earnings. (Holtzman, Venuti, & Fonfeder, 2003)
Enron
Prior to the collapse of Enron, as stated above, guidance for the accounting for SPEs was limited at best. Enron executives took advantage of complex financial structures to gain advantageous accounting treatment using SPEs. As Enron increased its portfolios of equities, they relied on SPEs, some of which they named Raptors, to halt their mark-to-market losses from spreading to the financial statements and decrease volatility. Enron argued that they were transferring their risk through hedging to other parties.
Enron used the SPEs in the following manner to hide the mark-to-market losses on their equity portfolios. The basic idea behind Enron’s hedge position was to use their stock price, which they believed would appreciate, to offset the losses on their equities. For example, Enron would first set up a SPE by making an investment in the entity. Then Enron would exchange treasury stock for a note payable. Enron would then purchase put options on its poor performing equities to offset their mark-to-market losses with a gain on the hedge agreement with the SPE. Conversely, the SPE would show a loss on the hedge agreement. Therefore, the SPE could only continue to write these losing derivative contracts if its underlying assets, its Enron stock, would continue to appreciate. If and when Enron stock depreciated, the SPE would have no gains to pay Enron on the hedging losses. (Enron thus made bets under the assumption that Enron stock couldn’t go down, much like the current financial crisis is a result of bets made by institutions believing that housing prices couldn’t go down.) Although this is the theoretical framework Enron used to justify their accounting treatments, in practice Enron abused the accounting for SPEs, acted unethically, and were not in form or substance operating in accordance with US GAAP. (Holtzman et al., 2003)
For one, Andrew Fastow, then CFO of Enron was the principal of the SPEs. In addition, as the principal he was also materially compensated. This violated the accounting principle that the SPE must be controlled by an independent third party, under the then relevant EITF series 90-15 (Financial Accounting Standards Board, 2001). As principal of the SPEs, he entered the SPE into numerous money losing deals to allow Enron to avoid taking losses for their poor performing equities. An example of this is the backdated options for a “hedging” contract for the equity Avici Systems between Enron and Talon (an Enron SPE Raptor).
Avici Systems was a poor performing long equity in Enron’s portfolio, for which Enron wanted to shield their mark-to-market loss. To this end, Enron entered a hedging contract with Talon. Although Enron had a business purpose for entering the contract, the transaction was not accounted for in accordance with US GAAP, due to the fact that the contract was backdated from September to August 3, the date that Avici Systems hit an all time high. This allowed Enron to offset their mark-to-market loss with a gain on their put option. An independent company certainly wouldn’t enter into a clearly money losing contract like this. In addition, falsifying documents in order to perform the backdating scheme is fraudulent.
Enron set up four such Raptors, often setting up a new Raptor as the old Raptor’s capital depleted. For example, in one case a Raptor’s capital was depleted to the point that it could no longer continue to write losing contracts with Enron. This prompted the company to enter into a “costless collar” with the Raptor. Under this contract, if Enron stock rose above a strike price, Enron would pay the Raptor, and if the Enron price fell below a strike price, the Raptor would pay Enron. If the Enron stock did not move above or below these strike prices, no action would be taken (Holtzman et al., 2003). Again, this shows that Enron executives were relying on Enron’s stock price appreciation to offset their portfolio losses. These examples are representative of Enron’s use of SPEs to avoid taking losses, minimize financial statement volatility, accelerate profits, and avoid paying debt (Schwarcz 2002).
Although it became clear that stricter guidance would have to be passed concerning the accounting treatment for SPEs, an interesting dilemma presented itself. Although there was a consensus that Enron used SPEs to hide losses and perpetuate the life of an otherwise insolvent company, a heated debate followed over how SPEs should be accounted for in the future. Some argued that Enron was in violation of US GAAP, which might suggest that the standards were not to blame. In this light, some argued that it was an internal control problem. Some blamed the auditors Arthur Anderson for their conflict of interest and independence, which resulted in new accounting regulations. The issue here is that if the problems were all control and ethics based then certain SPE’s could continue to exist off balance sheet, which is ultimately what occurred. In addition, Enron’s hedging contracts differed from most financing SPE’s which utilize securitization, it was argued.
In securitization, a company is able to reduce financing costs by dealing straight with the investors, eliminating the middlemen, or banks and their mark-ups. It is argued that this is an economic purpose for creating the SPE, unlike the purpose of balance sheet manipulation behind Enron’s SPEs. Also, it is argued that unlike Enron’s SPEs, in securitization deals the actual risk of the underlying assets is transferred to the SPEs and the investors, while Enron arguably didn’t transfer the risk to the SPE (Schwarcz 2002). For these reasons, certain SPEs would be allowed to continue to exist off balance sheet, but stricter guidance on SPEs was passed. (And so, a perfect opportunity to stop off-balance sheet financing is missed, which would contribute to the next financial crisis and future bankruptcies.)
Post Enron and Variable Interest Entities
In July 2002, Congress passed the Sarbanes-Oxley Act (SOX) in response to the accounting fraud leading to the demise of Enron. Included in the legislation was a call to study SPEs. This led to the issuance of FASB Interpretation 46, Consolidation of Variable Interest Entities, in January 2003, which is an interpretation of ARB 51. FIN 46 expanded the number of entities that would be consolidated in the financial statements, but it does not apply to qualifying SPEs (QSPEs) under FASB No. 140. In December 2003, the FASB revised FIN 46 releasing FIN 46R. (Baker et al. 2009, p. 110-111)
A Variable Interest Entity (VIE) is defined as a legal structure used for business purposes, usually a corporation, trust, or partnership, that either (1) does not have equity investors that have voting rights and share in all of the entity’s profits and losses or (2) has equity investors that do not provide sufficient financial resources to support the entity’s activities. A variable interest is an ownership or other money-related interest that increases when the entity has profits, and decreases when the entity has losses. A corporation with a VIE cannot rely on stock ownership when deciding whether to consolidate the entity or not. Rather, each party with a VIE must determine the extent to which it shares in the expected losses and profits of the entity. An enterprise that will absorb the majority of the entity’s profits or losses is the primary beneficiary and must consolidate the VIE (Baker et al. 2009, p. 110-111). Most structured finance deals are designed using fixed income investments, which by their nature do not result in variable interests. It is not a coincidence that these structures regulation was designed in this manner, nor is it a coincidence that they were structured in this manner, as will be explained in the following sections.
Qualifying Special-Purpose Entities
Just as FIN 46R was a response to SPEs used by Enron and its collapse, FASB 140 issued stricter guidance on SPEs. FASB 140 allows SPEs to exist off balance sheet if it meets certain requirements, in which case it is known as a qualifying SPE or QSPE. In order to qualify, an entity must be “demonstrably distinct from the transferor, its activities [must] be significantly limited, and [it must] hold only certain types of financial assets ((Baker et al. 2009, p. 109-110).” In essence, FASB 140 would allow securitization of assets and asset backed securities into collateralized debt or loan obligations (CDOs and CLOs) to exist off balance sheet, as well as other structured finance products.
Subprime Mortgage Crisis
It was argued vehemently that securitization of assets into SPE off balance sheet would be good for the American economy and American consumers. For example, Macaluso and Wilkinson argue that large liquid markets for securitized loans backed by credit cards, student loans, mortgages, commercial real estate, auto loans, leases etc., gives access to cheap credit to more Americans and American businesses. They continue arguing that this results in higher home ownership rates and a more robust economy. They go on to state how the government sponsored entities the Federal National Mortgage Association (Fannie Mae, abbreviated FNMA and ticker symbol FMA) and the Federal Home Loan Mortgage Company (Freddie Mac, abbreviated FHLMC and ticker symbol FRE) provide liquidity to the market by buying up qualifying mortgages from loan originators, and creating a SPE to sell the principal and interest cash flow streams of the loans to investors. This in turn provides financing to Americans who would not otherwise be able to obtain it, which increases home ownership. Then other companies, both public and private, applied this model to other debt instruments (2003). Furthermore, private companies applied the model to mortgages, in what alongside Fannie and Freddie, would cause the subprime mortgage crisis, which extended to the financial crisis. At the time, however, many agreed that such off-balance sheet financing was good for the economy.
One structured finance product that often meets the criteria to be accounted for as a QSPE is a collateralized debt obligation (CDO). To structure a CDO a parent company might sell bonds or fixed income securities in the capital markets. With this capital the SPE will purchase a portfolio of loans, such as a securitized portfolio of MBS. The SPE will use the cash flows from the MBS to pay out the bonds issued to the investors in the SPE. CDOs can become complex instruments, but this complexity is beyond the scope of this paper. What is important is that if the payments cease to come in from the MBS, then the SPE does not have the wherewithal to pay the interest payments on the bonds it issued. This results in a loss in market value for the SPE, which in turn results in a mark-to-market write-down for the parent company. This is a simplified version of what occurred in during the financial crisis.
Going Forward (Post-Financial Crisis)
The FASB is currently working to revise FASB No 140 and FIN 46R to eliminate QPSEs. The FASB has issued an exposure draft that would eliminate QPSEs; however, due to the nature and extent of the financial crisis the FASB has pushed back the implementation date to 2010 (Dammers, 2008). It is my opinion that 2010 is still too soon to expect the elimination of QPSEs due to the politicalization of the accounting process. The financial crisis led to the failure of numerous mortgage originators, banks, and investment banks. The remaining financial institutions were given numerous resources to remain solvent by the Federal Reserve including but not limited to capital infusions, lower interest rates on loans from the Federal Reserve, increased liquidity, and in some cases the backstop of losses. It is clear that the US government and the US Federal Reserve do not want to see these financial institutions fail, and as long as moving trillions of dollars worth of off-balance sheet loans onto the balance sheet is perceived to exacerbate the financial crisis, there will be tremendous political pressure on the SEC and in turn the FASB to delay this standard. Eventually, however, I believe the FASB will eliminate QSPE.
It is also my opinion that QSPE should be eliminated or consolidated on the parent company’s financial statements. Since financial statements are prepared for investors, all the company’s assets and liabilities should be reported on the financial statements. When companies hold material, but undisclosed amounts of assets off-balance sheet, investors do not have all the inputs to properly value the company. In essence, the investors have to trust that management is properly accounting for the SPEs. If the investing public doubts the value of the SPEs, and lack the information to decide on their own the value of the assets, they are highly motivated to flee from the investment. Furthermore, allowing off-balance sheet financing allows the company to avoid capital reserve or loss reserve requirements that would be required otherwise. In this case, if the assets go into default, the company may, like in the case of AIG, lack the capital to cover collateral calls to counterparties. This in turn exacerbates and spreads the financial crisis across the financial system, especially considering the business environment where derivatives such as credit default swaps (CDS) are used as insurance by the majority of financial institutions. These derivatives also avoid capital reserve requirements to be held by the financial institutions, resulting in a lack of capital reserves if a financial instrument goes into default or a company’s credit rating is downgraded resulting in a collateral call for the seller of the derivative contract.

Mon, 10/19/2009 - 10:12 | 103246 Reggie Middleton

Tell me, if the FDIC is insolvent now, and is taxing many smaller banks that did not contribute their fair share to this malaise to regain a 'semblence of solvency, why tolerate large banks that writes naked swaps as part of the depositor insurance program? How protected do you think grandma's CD or savings account is if Wells Fargo or Bank of America catches the AIG flu to the tune of $20 billion or so?

Is it me or is this risk truly unacceptable?

Mon, 10/19/2009 - 10:46 | 103295 Veritas

Couldnt agree more---have contacts at smaller banks,s&l's--strong balance sheets,great financial shape,getting killed with the new premiums(taxes) from the FDIC--one bank saw their premiums go up 400 pct-and why ? So the too big to fail banks get even bigger,and the little guy who is responsible gets squeezed---scary

Mon, 10/19/2009 - 10:05 | 103240 Reggie Middleton

In case it got lost in this rather large gathering of words, Bank of America is not the only one doing that AIG thang...

Mon, 10/19/2009 - 09:14 | 103214 Miyagi_san

The new normal...FASB is working on it: fractional reserve = off balance

TBTF

Mon, 10/19/2009 - 09:09 | 103210 torabora

Hey, what about the green shoots?

If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It? Pt 4 - Wells Fargo

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