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New FASB Proposal Could Hammer CDO Mart


A new Financial Accounting Standards Board proposal may affect the capital structure of collateralized debt obligations and slow the market's expansion, veteran CDO players say. In a board meeting last Wednesday, FASB proposed an increase in the minimum required equity in special purpose entities (SPEs) held by third party investors from 3% to 10%. The equity is the non-rated, highest yielding and riskiest tranche of the notes in a CDO deal.

The increase of the equity held by outsiders is viewed by the marketplace as problematic as it may threaten the off-balance sheet treatment asset managers enjoy when sponsoring a CDO, explains Jim Mountain, partner with Deloitte & Touche's securitization group. If an underwriter cannot sell at least 10% of the equity to outsiders, the CDO would be viewed as a subsidiary of the collateral manager and the assets of the deal would go back onto the balance sheet of the collateral manager, or "consolidated," he explains. This would represent a challenge for managers, he continues, as most of the existing CDOs are off-balance sheet. "Collateral managers have been working hard to build a CDO market to avoid consolidation," he notes.

The goal of the FASB proposal, explains Ray Simpson, FASB's project manager, is only to clarify consolidation criteria. In order to deconsolidate--or obtain off-balance sheet treatment--a collateral manager would have to increase the minimum size of independent third parties.

Simpson says FASB plans to issue an exposure draft next month. From there, CDO market players can review it, suggest changes and FASB will take those changes into consideration in crafting a final draft. He says FASB hopes to finalize the standard this summer.

Anthony Thompson, head of CDO research with Deutsche Bank, says, "the heightened focus on the 3% rule, in my opinion, is a knee-jerk reaction to the fallout from the Enron crisis." David Lukach, co-head of structured finance and partner with PricewaterhouseCoopers, says, "[FASB] is under a lot of pressure. The Securities Exchange and Commission, Congress, everyone is looking at FASB for answers."

A sellsider predicts issuance may be endangered as underwriters will be under the pressure of selling a higher amount of equity. He speculates underwriting fees may rise since placing the riskiest notes is already a "tough sale." Eileen Murphy, global head of CDOs with Barclays Capital, says "the distribution of the equity piece has always been a challenge. This would create an even greater challenge."

Jason Kravitt, partner with Mayer Brown & Platt, securitization attorney and co-founder of the American Securitization Forum, says the new rule would "make it tougher for investment-grade CDOs to work," because there is less yield in those deals to allocate to equity investors. Deloitte's Mountain worries that the rule may change the overall capital structure of CDO deals. "By forcing structurers to issue more equity and less debt, deals will become more expensive, less efficient," says a sell-side CDO official. Finally, Thompson worries that, "A change in the rule could result in managers retaining no equity in the deals."

Some analysts believe that investors are more skittish for deals in which a manager has no direct stake. Kravitt concludes that, "The rule is not appropriate." He adds that, "It is the toughest accounting problem we've had so far. But I am optimistic. We've worked out the FASB 140 standard. Let's see if we can solve this one."

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