Affordable Housing Institute : US

By: David A. Smith

 

[Continued from yesterday’s Part 2 and the preceding Part 1.]

 

By 2002, as we’ve seen in the two preceding parts, expansionary pressures on global capital were bringing forces into alignment with means, motive, and opportunity to push asset prices up. 

 

 

If we’re all rising, we’re all grounded, aren’t we?

 

 

The major expansion in capital availability, together with the technological infrastructure to move billions of dollars with a mouse click, in effect freed money from the normal de-investment constraints that reduce volatility and flexibility in capital allocations and capital investment. 

 

When one magnifies leverage and speed of response, the normal outcome is greater risk (measured by volatility) and greater concentration of risk.  Securitization does this.  In so doing, it distances the creation of risk (at the individual property level) from the acquisition of risk (by the holder of a structured financial instrument).  All this is fine – risk is supposed to migrate, that’s what insurance is – provided that those risk pools are visible to the capital markets, so they can evaluate the counterparty risk.

 

Think of risk like alcohol diluted in water, and financial structuring like distillation.  It purifies one product (the boiled-off water) and concentrates another (the Tennessee lightning). 

 

Y’all gotta know what yer drinkin’, that’s all

 

Either has its use, provided the consumer has adequate disclosure:

 

Yew know what yer drinkin’

 

That’s what made the next invisible story so significant:

 

2003, January: Issuance of FIN 46 (later FAS 167)

 

In January, 2003, seeing a problem approaching, the Financial Accounting Standards Board (FASB) issued the inelegantly named FASB Interpretation Note (FIN) 46, Consolidation of Variable Interest Entities – an interpretation of ARB No. 51.  A response to the Enron shenanigans, FIN 46 sought to prevent sponsors from playing hide the ball with risk.  The FASB created a paternity test for financial offspring, in prose so turbid as to be nearly indigestible:

 

Norwalk, CT, January 17, 2003—In an effort to expand upon and strengthen existing accounting guidance that addresses when a company should include in its financial statements the assets, liabilities and activities of another entity, the Financial Accounting Standards Board (FASB) has issued Interpretation No. 46, Consolidation of Variable Interest Entities.

 

The critical term is ‘to consolidate.’  When does a company (Parent) that has shares in another company or venture (Offspring) have to account for all its offspring’s adventures and misadventures? 

 

This thing of darkness I / Acknowledge mine

 

To use a current-day conundrum, when does Dubai have to consolidate Dubai World, and when does Abu Dhabi have to consolidate Dubai?

 

Before FIN 46, the test was simple: control. 

 

Until now, one company [Parent] generally has included another entity [Offspring] in its consolidated financial statements only if it controlled the entity through voting interests.  

 

That test let folks like Enron hide steaming piles of risk in special-purpose vehicles (SPVs or SPEs) that could then be shut away in nearby opaque risk garages, to which they had the only key but whose odoriferous contents they were not obligated to report.  As explained in CFO Magazine:

 

Early in his tenure as chairman of the Financial Accounting Standards Board, while the Enron scandal was raging, Robert Herz was confronted on Capitol Hill by a senator from the South.  As Herz tells it, imitating the lawmaker’s distinctive drawl, the senator demanded to know when FASB was going to “outlaw the use of these dummy co-poh-ray-shuns.”

 

Putting auditors in the driver’s seat? Robert Herz

 

Herz’s solution was FASB Interpretation No. 46 (FIN 46), an economic test designed to fill in when legal definitions of ownership fail. The crux of the test: who stands to gain or lose the most from an SPE whose ownership is otherwise unclear?  (Such SPEs are now dubbed variable interest entities, or VIEs.)  Whichever company proves to be the VIE’s “primary beneficiary,” said FASB, must consolidate the entity’s financial data in its own statements.

 

FIN 46 changed the consolidation definition from control (which could be manipulated or obfuscated) to variability (upside and downside).

 

Interpretation 46 changes that by requiring a variable interest entity to be consolidated by a company if that company is [a] subject to a majority of the risk of loss from the variable interest entity’s activities or [b] entitled to receive a majority of the entity’s residual returns or both. A company that consolidates a variable interest entity is called the primary beneficiary of that entity.

 

Basically, FIN 46 said there are no orphans: every child has one and only one father.  That father, who had to acknowledge patrimony (and hence implicit financial responsibility) was the entity with most of the upside or downside.

 

Yes, unfortunately, he’s mine, by George

No More Make-Believe
Before FIN 46, the orphan status of SPEs was a large part of what made them so useful. Generally speaking, SPEs are dummy corporations, created to own assets that a company doesn’t want on its own books for any of a variety of reasons. For example, for securitization purposes, an SPE increases the value of the assets as collateral by sheltering them from the company’s creditors. As long as their “sponsor” company didn’t have voting control or too large an equity stake, SPEs were considered independent.

 

The guidance was issued as an interpretive note rather than a standard because the FASB wanted to get it into the marketplace quickly, to prevent collapse of investor confidence in the wake of Enron’s implosion. 

 

En-who?

 

FIN 46 was later supplemented by FIN 46R, then subsumed into FAS 167.

 

Like many a putative safe harbor before it, FIN 46 immediately became the boundary standard for ethics.  As constructive critic Vinod Kothari put it, largely quoting S&P:

 

Standard and Poor’s … reported that “the majority of securitization professionals worldwide report that they are overwhelmingly frustrated, skeptical and confused by the new set of rules for off-balance-sheet financing, characterizing it as an unnecessary and costly burden on an otherwise healthy market.  Moreover, the regulation fails to adequately tackle the problem of corporate malfeasance that it was originally designed to address, market participants said.”

 

Along with thousands of others, I can testify how much accounting brainpower was consumed defining the maximum perimeter of entities in which the Parent had a big economic stake without the dreaded FIN 46 consolidation.  This still goes on today, consolidation being the Thing To Avoid At All Costs.

 

Simple, isn’t it?  Vinot Kothari’s FIN 46 flow chart

 

FIN 46 has all sorts of unintended consequences.  An investor limited partner in a LIHTC syndication might have 99% of the profits, losses, and cash flow, with a completely non-recourse position, yet compelled under FIN 46 to consolidate the property’s entire operating performance (including its non-recourse loans) onto the investor’s balance sheet. 

 

“Respondents were consistently incisive, reproachful and vehement in their criticism of FASB’s year-long process of developing and vetting FIN 46, conveying in strong, pointed language their dissatisfaction with FASB’s responsiveness to the securitization market and their disappointment with the final Interpretation, which many construe as an overly broad, ‘over-reaching’ measure which is treating a very specific abuse (inadequate and misrepresentative corporate disclosure).”

 

As you can imagine, this led to contortions by which entities sought to avoid having to consolidate.

 

A total of 470 participants from the US and Europe participated in the survey. Most also felt that the market will adapt itself with new structures which simply cosmetically re-engineer SPEs to fall out of the definitions of the Interpretation.

 

That was the invisible story.  FIN 46, which sought to make things more transparent, in fact made them more opaque.  While investors basked in the illusion of transparent consolidation, in reality they were absorbing ever more risk.

 

Aftermath.  FIN 46, now renamed as FAS 167, is now a permanent part of the landscape, but the puzzles it poses remain unsolved.  Consolidation is still a bete noire in accounting and CFO circles.

 

You still haven’t dealt with me

 

2003 onward: Explosion of unlicensed insurance: Credit Default Swaps

 

Dematerialized capital and massive computing power enabled the creation not just of complex securitization but also of derivative instruments – securities issued based on the performance of other securities.  As I explained at some length, credit derivatives are risk moonshine [Posted June, 2007]:

 

If in fact risk has migrated to those better able to manage it, then the system should be able to tolerate more risk without overloading, because the risk is distributed.

 

It filters through the whole system

 

We have seen something like this in the weakening residential home market and its followup consequence, the subprime shakeout. The housing market’s crumple zone has dispersed risk both among participants and over time, so that although it’s clearly caused localized harm, there has been no systemic or structural failure [June, 2007, oops – Ed.].

 

So far credit derivatives have proved a triumph of the financial sector’s ingenuity. By dividing the bond market into digestible chunks, they have increased investors’ appetite for corporate debt. That may well have lowered the cost of capital—good for the economy, since it should allow companies to invest more over the long run.

 

I’ll give the Economist its caution, but it seems inescapable to conclude that better risk allocation expands capitalization and contributes to a lowering of interest rates.

 

But credit derivatives have yet to face a really bracing test. They have grown in a time of low interest rates and narrow credit-spreads (an extra yield over government bonds to offset risk).

 

Everyone looks like a world-class bicyclist when pedaling downhill.

 

No dopes here, just athletes

 

What then are these unicorns, the derivatives?

 

Credit Default Swaps were a particularly dangerous invention, because they were essentially unlicensed insurance [Posted December, 2008]:

 

“I bet I’ll die soon.”

“We bet you’ll live a long time.”

– The essential bargain in life insurance

 

“I’ll take that bet.”

 

When you buy life insurance, you’re selling a risk (that you’ll die) and the insurer is buying that risk.  You’re paying the insurer to buy it. 

 

I who control my lifespan bet I will die, and you who have no say in it bet I won’t.  Talk about agency risk!

 

Because of its perverse incentives, I’ve always found the insurance among the most curious financial products humanity’s ever invented.  The insurance-craving-murderous-spouse has been a staple of noir fiction ever since Fred MacMurray in 1944’s Double Indemnity (even the title screams insurance!) and smooth Ray Milland in 1954’s Dial M for Murder.

 

Dial M for money?

 

As compared with other complex securities, credit default swaps were (and are) especially dangerous, because they introduce two new risks that the markets proved unable to appreciate.

 

 

1. Infinite replication means infinitely diluted credit-worthiness.  CDSs are side bets.  Disconnected from the direct participants’ capital, they can be written in any desired multiple of the company’s market capitalization.  We see the same effect in sports betting, where obscure events can attract wagers whose total value is many multiples of any purse for which the athletes are competing, with resulting potential for match-fixing.

 

$7,000,000 bet on me losing? 

 

2. Financial incentive to kill a company.  If enough CDSs are written where hedge funds (say) profit from a company’s demise, and the target is subject to capital requirements, then there is a serious Dial M for Murder risk: giving third parties a financial incentive to do in another.

 

Combine those two new risks and you can have speculators who load up, betting on the demise of a particular company, and who then conspire to make it happen (especially in concert with another hidden story, FAS 157, that I’ll profile below). 

 

Patience is a virtue, but killing things is so much quicker

 

As I put it [Unfortunately long after the fact; posted December, 2008]

 

We’ve already seen, in Unlicensed Insurance (Part 1, Part 2, and Part 3), that Collateral Default Swaps (CDSs) are like double-indemnity insurance, or side bets on a football game: you and I speculate on a third party’s fortunes, with me hoping they’ll lose.  If such a bet took place only in a financial private club, that would be one thing, but much like the Double Indemnity situation, a massive amount of short selling can destabilize the stock price.

 

The result was predictable.  CDS volume exploded:

 

Bets vastly in excess of collateral to cover them all

 

As the Economist’s chart shows, the market is repricing risk, and probably over-pricing risk.

 

The next shock could be the failure of a hedge fund with a big swap book, given the spike in redemptions and margin calls many funds face, thinks Pierre Pourquery of the Boston Consulting Group. Hedge funds wrote almost a third of all credit protection last year (see chart 2).

 

When the speculators are betting you’ll die, watch out

 

Selling CDSs would be like hedge funds, who are the latest generation of the ’smartest guys in the room’ – big bets, no assets required, just enormous risk tolerance and confidence.   That’s been the risk in the CDS market: not that you’d never need the protection, but that when you needed it, it wouldn’t be worth anything.

 

“Yes, I killed him. I killed him for money – and a woman – and I didn’t get the money and I didn’t get the woman. Pretty, isn’t it? I bet he croaks soon.”

– Walter Neff, Double Indemnity

 

Do I laugh now, or wait ’til it gets funny?

 

Hyperinflation of CDS in force created a condition of potential panic-inducing short selling – but that by itself would not have been such a problem … were it not for the decade’s next invisible story.

 

Aftermath.  Credit Default Swaps remain, and will do so indefinitely, but now the capital markets understand the counterparty risk (the potential “never-pay policy”). 

 

Kill him for me.  I’ll make it worth your while.

 

Issuers of CDSs will be scrutinized as never before for their credit-worthiness.

 

Is she credit-worthy, I wonder?

 

[Continued tomorrow in Part 4.]

 

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