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Banks Exploring Balance-Sheet Workaround
Asset Backed Alert, Harrison Scott Publications Inc. (April 30, 2010)

Royal Bank of Canada has implemented a tactic designed to keep the assets of its U.S. commercial-paper conduits off its balance sheet.

Bank of America, Citigroup, J.P. Morgan and Wells Fargo are also considering the maneuver, which entails the sale of high-yielding "expected-loss" notes that would essentially represent first-loss exposures to the banks' commercial-paper vehicles.

At issue are the Financial Accounting Standards Board's FAS 166 and 167 rules, and an accompanying directive issued by the FDIC, Federal Reserve, Office of the Comptroller of the Currency and Office of Thrift Supervision. Under the FASB guidelines, U.S. banks must hold their conduit pools on balance sheet. The FDIC group, meanwhile, has ordered a larger-than-expected buildup of capital reserves against those assets from July 1 to Sept. 30.

The banks' thinking is that by bringing in expected-loss investors, they wouldn't face the largest risk from their conduits and therefore could keep the vehicles' assets off their books. Part of the formula is that the investors would have veto power over any receivables added to the conduits.

Potential expected-loss investors include LCP Capital of New York. The firm has been pitching the idea to domestic and foreign banks that run conduits in the U.S., and says many are taking a hard look at the concept. It hasn't struck such a deal this year, but already had some similar arrangements in place with institutions outside the U.S.

LCP has also agreed to take expected-loss notes, and control, attached to term securitizations from an undisclosed credit-card lender. Issuers in that sector are also seen as particularly vulnerable to the FASB rules.

Expected-loss notes aren't new. In fact, many conduits sold them to ensure continued off-balance-sheet treatment following the 2003 implementation of FASB's FIN 46(R). But they didn't give noteholders a say in collateral selection. Most retired the instruments last year based on an assumption that FAS 166 and 167 would render them ineffective, LCP partner Stephen Ceurvorst said.

Auditors are apparently concluding otherwise. While the addition of expected-loss notes results in higher funding costs, the expenses are lower than what operators would face if they kept their vehicles' portfolios on their books. Even though many banks already hold their conduit assets on their balance sheets, they have been looking for ways to achieve off-balance-sheet treatment ever since regulators proposed the tougher reserve requirements last year.

And as those set-asides loom closer, the institutions' efforts are expected to intensify. "Banks are trying to scramble ahead of that," one source said. Along with expected-loss notes, RBC's peers are looking into other maneuvers that would have similar effects. However, it remains to be seen whether rulemakers will allow any arrangement resulting in off-balance-sheet accounting treatment for U.S. conduits. Even if the use of expected-loss notes adheres to the letter of the law, some market insiders think regulators will simply tweak their rules to disallow it. "Regulators are just saying 'We're bringing [conduits] on balance sheet,' " another industry player said.

It's also unclear if banks' senior managers will sign off. Big U.S. institutions, for instance, could face political pressure if they are seen as undermining regulation. RBC runs three U.S. conduits with a combined $14.1 billion of outstanding paper: Old Line Funding, Thunder Bay Funding and White Point Funding.



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