[00:04.13]Tesxt 6.1 Cleaning up the balance she
[00:08.44]However ,it is not always the limit on borrowings power which prompts a company to seek off balance-sheet financ
[00:15.65]After all, the articles of association can ,with shareholder's approval, be amende
[00:21.21]That change will not help the management if the main problem for the business is that its borrowings are simply too hig
[00:28.19]The stock market is acutely aware of the dangers for a company which has hign levels of debt that must be service
[00:34.87]One of the crucial factors in assessing a company is its gearing ,the proportion of new borrowings to shareholders' fund
[00:42.58]When gearing becomes uncomfortably high, the stock market begins to get a little worried and the pressure is on the company to reduce the rati
[00:50.81]When a company finds itself in the unfortunate position of having high gearing which cannot be reduced, or even held stead
[00:57.60]out of internally generated funds, it is easy to see why the management might be lured into one of these artificial funding scheme
[01:05.59]The off balance-sheet finance may be applied to reduce existing borrowing,thus bringing down the gearing rati
[01:12.57]or it may be secured in order to embark on an important project or acquisition which is needed for the company's long term future.
[01:19.49]Either way,it still represents a distortion of the company's true financial position which prevents users of the accounts obtaining a full and fair understanding of its affair
[01:30.10]and it may lead to an investment decision being taken on inappropriate ground
[01:34.69]The position was summed up by the ASC in its foreword to Statement of Standard Accounting Practice 21, which deals with leases and hire-purchase contract
[01:44.88]Leasing had become a substantial source of off balance-sheet finance, and the standard was designed to recognise the substance rather than the legal form of a leas
[01:54.10]to ensure that leased assets and the cooresponding liabilities were reflected in the account
[02:00.01]The ASC said:' When a company is leasing a substantial amount of assets instead of buying the
[02:06.64]the effect is that ,unless the leased assets and obligations are capitalised ,potentially large liabilities build up off balance-shee
[02:15.71]equally the leased assets employed are not reflected on the balance-shee
[02:21.24]These omissions may mislead users of a company's accounts--both external users and the company's own managemen
[02:28.38]It was quite a bold move by the AS
[02:31.93]The conflict between the legal form of a transaction and its practical substance is not easy one to resolv
[02:38.62]However ,the introduction of the leasing standard passed off without too much trouble,depite the complexity of the subjec
[02:45.09]By and large companies have been happy to capitalise the assets purchased under finance leases,and,to incorporate the corresponding liability to the lessor in the balance-sheet.
[02:54.89]There is still some uncertainty over the distinction between operating lease
[02:58.89]which do not need to be capitalised ,and the pure finance leases which must be reflected in the balance-shee
[03:04.87]This aside, the leasing standard must constitute something of a victory for the AS
[03:10.75]The question now, is whether it will be able to repeat its success in dealing with leasing on the new and more sophisticated off balance-sheet financing schemes which have sprung up more recentl
[03:21.61]Text 6.2 Bold proposal may lay balance sheet bare
[03:28.51]Consultation ends today on the Accounting Standards Board's proposal that securitised assets and related liabilities should be shown on the face of the balance shee
[03:38.02]It seems to have caused a great deal of consternatio
[03:41.15]In the UK,this change primarily affects those banks,insurance companies and mortgage companies which have used securitisation to fund their mortgage lendin
[03:51.84]Building societies have yet to take advantage of this funding technique,but building societies,too,appear to have greeted the ASB propsal with mixed feeling
[04:01.79]The opponents of the proposal argue that it could stop them securitising
[04:06.94]To understand why they think that may happen,it helps to know a little about the proces
[04:12.19]Securitisation is an inelegant word to describe long term structured fundin
[04:18.25]The most common method of securitisation is for the originator-the bank,insurance company and mortgage compa
[04:25.14]to transfer a pool of mortgages,to a specially formed compan
[04:29.87]This company ,called the issuer, may enhance the pool's credit quality, often by buying insuranc
[04:36.92]It then issues bonds using the pool as securit
[04:40.56]The process is similar to any normal method of arranging secured deb
[04:44.97]Out of the mortgage interest it receives, the issuer pays interest to bondholders and covers its own cost
[04:52.52]Part of those costs will be a fee to the mortgage administrtor, which is often ,but not always, the originator itsel
[04:59.60]Any remaining profit is usually passed back in one form or another, again to the originato
[05:05.74]In a nutshell, the ASB argues that where the originator continues to enjoy an economic benefit from the securitised mortagage
[05:13.03]whether or not the issuer is a direct subsidiary, the issuer's assets and liabilities should appear on the originating group's consolidated balance shee
[05:22.66]The aim of all this is to present as complete a picture as possible of the total assets and liabilities of the group
[05:29.56]and when viewed in this light the logic of this proposal is frankly difficult to refut
[05:34.99]There would be no problem but for the fact that most mortgage lenders who have used securitisation as a funding method have done so with the specific aim of getting the assets off the balance shee
[05:47.22]Ever since securitisation first appeared in the UK, many have regarded this ,quite incorrectly, as its principal advantag
[05:55.50]Lenders,it is said, can avoid having to use unnecessarily large amounts of capital to back their securitsed loans by shifting them off the balance shee
[06:05.66]That in turn reduces the figure which regulators take into account when working out their minimum capital requirements
[06:13.00]with the result that it frees capital for other things--and also substantially reduces the apparent level of gearin
[06:21.07]Many lenders argue that this state of affairs is quite acceptabl
[06:25.78]Their view is that the balance sheet should only show assets which carry significant ris
[06:30.71]and since the risk associated with securitised assets is remote or even non-existent
[06:36.28]there is no point in clogging up balance sheets with irrelevant figure
[06:40.43]That argument is specious for two reason
[06:43.41]Firstly, risk has never been a determining factor in consolidatio
[06:48.01]Secondly, even if it were relevant,those who use this argument are referring solely to the credit risk,and not to all the risks inherent in lendin
[06:58.43]Whilst the credit risk may indeed be insured away,the risk that profits and service charges will fluctuat
[07:04.91]sometimes by enough to turn into losses,will clearly remai
[07:09.14]If these losses are being borne by the originator, the parent company is obviously bearing both a liquidity risk and a margin ris
[07:17.79]The only way to avoid any form of risk is to sell the assets outright ,which implies that the originator receives no further economic benefit whatsoever from the mortgage
[07:27.90]However ,a sale is clearly a very different process from a securitised bond issu
[07:34.30]Looked at in this light, the ASB seems to have a pretty unassailable cas
[07:39.78]Does it, however,follow that the securitisation market is dea
[07:44.48]Not at all, The principal advantage of securitisation is not that it takes assets off the balance sheet
[07:51.80]but that it provides non-recourse funding to maturit
[07:55.56]A lender can offer long term loans secure in the knowledge that the funds to finance them will be there until either the loan matures or the borrower decides to repay i
[08:05.15]That is a luxury denied to many lenders, building societies included, who fund their mortgages principally out of short term deposits either from retail savers or from larger scale investor
[08:17.55]Apart from the constant need to adjust rates to ensure that volatile short term funds are not withdraw
[08:24.19]this funding method carries a large liquidity ris
[08:27.35]As the aftermath of the BCCI affair earlier in the year showed
[08:31.74]it does not take very much for investors to become nervous ,with potentially disastrous consequences for lender
[08:39.18]If the ASB proposal becomes mandatory ,as I have little doubt it will, there may well ,at the margi
[08:46.21]be a reduction in the number of organisations issuing mortgage backed securities, despite their funding advantage
[08:53.73]But those who continues to securitise will be doing it for the right reasons and they will have shown themselves to be long term participants in the mortgage marke
[09:02.75]There may even be an increase in sales of mortgage portfolios by institutions unwilling or unable to carry the assets and related liabilities on their balance sheet
[09:13.04]To some extent this is already happenin
[09:15.60]In the last 12 months, Household Mortgage Corporation has acquired three mortgage portfolios totalling some $ 600
[09:25.00]We are negotiating about several mor
[09:27.64]Although these sales were made with comprehensive warranties, there is no doubt that they were genuine sales within the ASB definitio
[09:35.71]They immediately reduced the size of the respective vendors'balance sheet
[09:40.26]Despite its potential impact on the mortgage market, any accounting change which results in better,clearer accounts is to be welcome
[09:48.59]If this particular proposal can bring about better understanding of the real merits of securitisation as well,then it is very good new |