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Expected Loss Notes Could Solve CDO Consolidation Puzzle

Collateralized debt obligation and commercial paper conduit structurers and accountants are working on ways to transfer the downside risk of portfolios to avoid having to put the whole structure on asset managers' and banks' balance sheets. The answer is to make hedge funds consolidate the deal. This is done by transferring a majority of the downside risk to hedge funds, through instruments dubbed expected loss notes, according to accountants. These are similar to the equity tranche of a CDO in which the hedge fund's principal is reduced each time an asset defaults.

A U.S. accounting rule, known as FIN 46, came in to effect on July 1 and attempts to put off-balance sheet entities back onto the balance sheet. Because the main driver for CDOs is often to get the assets off balance sheet, the new accounting rules pose a huge problem for the securitization sector.

Tom Fritz, managing director in asset-backed securities at Standard & Poor's in New York, said four or five conduit sponsors have completed the documentation for such structures. He expects more to follow before the institutions have to report their financial statements on Sept. 30.

The risk transfer works because hedge funds are not regulated and as a result only care about the economics of a trade, according to a hedge fund manager. In this case, a commercial paper conduit has to hold regulatory capital against a position and it may be cheaper for that entity to sell it, at above market value, to a hedge fund which does not have to hold capital against the trade.

FIN 46 decides which entity must consolidate the spv by looking at who holds the majority of the downside risk before looking at who holds a majority of the upside, explained Peter Jeffrey, partner at PricewaterhouseCoopers in London. The expected loss notes mean a majority of the downside risk can be transferred to a hedge fund making that the institution which has to consolidate, while keeping some of the upside, such as a portion of the excess spread, for the manager. Officials said hedge funds could be enticed into purchasing the notes through several factors, such as below par pricing. In addition, bankers are looking at structuring CDOs of expected loss notes to diversify the risk.

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