Janet Tavakoli, Tavakoli Structured Finance, President

Janet Tavakoli is the founder and president of Tavakoli Structured Finance, a consulting firm providing advisory services, education, and research in structured finance, securities, derivatives, Sarbanes-Oxley issues, Enron, and credit derivatives for financial institutions and institutional investors.

  • 26 Oct 2003
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Janet Tavakoliis the founder and president ofTavakoli Structured Finance, a consulting firm providing advisory services, education, and research in structured finance, securities, derivatives, Sarbanes-Oxley issues, Enron, and credit derivatives for financial institutions and institutional investors. Tavakoli argues that FIN 46 is a poorly conceived rule and she discusses risk management and the difficulties of reigning in star performers who may be crossing ethical lines.

LMW: Why is FASB initiating the accounting change on CDOs?

I am not sure FASB intended to target CDOs. What they were trying to do was to prevent the kind of abuse that occurred with Enron, which was pretty egregious in using offshore vehicles to change the character of cash flows and then to account for them inappropriately. I believe FIN 46 was a reaction to that, but unfortunately for practitioners, FIN 46 is messy.

In addition, [FASB] is making further changes [to rules] that I don't think were broken in the first place that may have adverse consequences. We want to avoid unnecessary consolidation when it is not really warranted. In the case of CDOs, especially some investment-grade CDOs where very little equity is required, there is a danger that you might be consolidating assets that it really doesn't make sense to consolidate.

LMW: What can CDO managers or underwriting banks affected by the proposed changes do to avoid consolidation?

A financial institution can still avoid consolidation in a couple of ways. The problem is that the interpretation of the ways to avoid consolidation is open to many different interpretations and FASB hasn't provided adequate clarity yet. In fact some of the attempts at clarification have been many multiples of paperwork beyond what the original rule was.

If you have a qualifying SPE, then you can avoid consolidation, but one of the knock-on effects of FIN 46 is a new proposal--FASB 140--that is going to make it more difficult for current qualifying SPEs to maintain that status. If new SPEs are formed in future they may not have the ability to get that QSPE status as easily, and that's not good news, especially for banks that securitize assets.

Secondly, FIN 46 applies to SPEs that do not meet the qualifying SPE criteria. So before you tick that SPE box, you first have to decide whether or not your SPE is a Variable Interest Entity (VIE). It's not a VIE if the total equity investment is sufficient to finance activities without additional financial support and that is not necessarily 10%--it might actually even be less. But you are going to have to educate people so that this is not misinterpreted. In addition, it's not a VIE if equity investors have a direct or indirect ability to make decisions through voting or similar rights. Or they have an obligation to absorb expected losses and the right to receive residual returns.

Now, if it is not a VIE then you apply the consolidation guidance of FASB 94, which itself is open to interpretation. If it is a VIE, then you have to determine the primary beneficiary for consolidation purposes and there is a lot of room for confusion on that. If the equity is adequate and if it's well dispersed, the VIE may not apply. But again this is subject to interpretation and one of the things that has a lot of people involved in the CDO market nervous is that I may in good faith interpret it one way, and later may be charged with trying to get around the rules when all I did was make an honest mistake.

Is there a way to get around this--to still use SPEs and not worry about consolidating them? One possibility is that banks may go to European banks, as an example, and pay them fees to buy and securitize their assets. If a bank securitizes in the U.S., it will be very difficult to avoid consolidation and this is unnecessarily the case. So, instead the bank will pay a European bank a fee to securitize these assets using a SPE. You buy the assets from us and you bring the deal and that way avoid the issue of consolidation altogether. It would very clearly be a true sale. But again it creates what could be unnecessary complication in the CDO business.

LMW: Why did more institutions not oppose FIN 46 and how should the market have responded to the post-Enron situation?

I was astonished at how little outcry there was about FIN 46 at the beginning. What astounded me was how late the American Bankers Association raised their objection. I would have thought that banks would be waving their hands in the air from day one. But again, how should the market have addressed the Enron situation? The answer may surprise you because it's not going to focus on FIN 46, its going to focus more on human nature. The problems that we saw with Enron are similar to the problems that we saw [with] stock-equity analysts giving over rosy pictures of WorldCom and with several other bits of financial chicanery over the years, including financial chicanery involving the Vatican bank more than 20 years ago and offshore SPEs.

FIN 46 is an honest attempt to try to look at the problem, but if you look at what Enron was doing, you had investment banks involved, you had sureties involved and none of their issues are going to be addressed by FIN 46. A lot of people were involved in the transactions that should have asked better questions. If you have a hot deal and you're one of the golden boys, your risk managers or other people will be afraid for their jobs if they question what you are doing too vigorously. It's really a question of line management, and is something theSecurities and Exchange Commission has been battling for years--the invulnerability of key people and their ability to get away with almost anything if it appears they are making money.

In the Enron case, the risks, their hidden exposures to Enron, were not apparent to their credit managers in some cases, such as the Citigroup and J.P. Morgan deals where they used the oil and gas contracts to disguise the fact that they were giving Enron loans. Although the loans did not show as credit risk to Enron, it appeared they were doing really good business with Enron.

People don't drill down and question. These are complicated deals and these are smart people so if you are asking for an explanation and you get a glib explanation, you're eyes may glaze over if you are not an expert in this field. You may be overwhelmed with the quantity of information and rely on them to interpret it, which can be a mistake as people are happy to mislead you. The root cause is not going to be solved by another FASB accounting rule, in fact FIN 46 has the potential to create more problems than it solves, yet it does not address the root cause of the problem.

I am a big proponent of structured finance because I believe that people should earn big fees for good complicated structures that work. Part of the job of good structured finance people is to create structures that have good integrity, originality, and to push the envelope a little bit. But when people cross ethical lines--that's where their managers have to step in and be the cooler heads. This has to happen at the line-management level.

Any new rule like this, the first thing you do is say; How can I work around some of the nastier aspects of this rule? Many aspects of FIN 46 make it a ripe for being a bad rule. It's difficult to interpret, it's confusing and to me that's the definition of being a bad rule.

LMW: Will FIN 46 be struck down?

I'm not in the frontline and it's not for me to go to FASB. It's really up to the people affected to lobby FASB hard. The lobbying initially was not effective enough. Some of the comments letters that I read by individual banks made me wonder whether they had actually read the rule. The jury is still out and I await the final results.

  • 26 Oct 2003

GlobalCapital European securitization league table

Rank Lead Manager/Arranger Total Volume $m No. of Deals Share % by Volume
1 Citi 2,007 6 16.61
2 Goldman Sachs 1,798 4 14.88
3 BNP Paribas 1,434 4 11.87
4 Barclays 1,097 2 9.08
5 Morgan Stanley 1,094 2 9.06

Bookrunners of Global Structured Finance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • Today
1 Citi 20,542.69 67 10.85%
2 JPMorgan 18,820.53 50 9.94%
3 Bank of America Merrill Lynch 17,976.22 56 9.49%
4 Wells Fargo Securities 16,568.24 48 8.75%
5 Barclays 13,499.53 45 7.13%