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Author: | Published: 10 Oct 2001
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Liquidity is essential for commerce. The higher the cost of liquidity, the greater the drain on commerce. This year, short-term rates paid by US banks for commercial deposits have declined substantially, in line with reductions in the Fed Funds rate. Rates for long-term loans, those which provide funds for capital goods acquisitions, did not decline by as much. Moreover, the relative rates charged on loans to non-investment grade firms, those that were the US engine of growth, have risen alarmingly since early 1998.

Well before the events of September 11, US businesses were earning less on short-term investments and, for the most part, were required to pay much more for loans used to invest in capital goods that support productivity growth. This meant businesses earned less and began to hold back on capital goods purchases. Moreover, as loans originated in the mid-1990s came up for renewal, many US businesses faced demands for repayment at a time when new loans were not available, or available only at rates that businessmen could not afford to pay.

The US engine of growth appeared to be stalling despite monetary and fiscal policy efforts at revival. Will new efforts to increase liquidity and improve securitization procedures be enough to jump-start financial markets and lift the US out of a crisis?

BUSINESS MIRRORS FINANCE

Figure 1 reflects major trends in US financial markets over the past decade. It shows the relative long-term financing cost for non-investment grade companies (over 95% of US businesses) compared to their highly rated competitors.

Considering the impact of rising spreads on non-financial enterprises, the chart makes it easy to understand why the US was experiencing a business recession. Since about 80% of the world's financial intermediation is conducted in, or through, the US, this chart also explained trouble in US markets that was trouble for the world.

In the past three years, the virtuous trend toward lower funding costs that financial competition bestowed on US markets from 1992 to 1998 appeared lost. The virtuous cycle was replaced by a vicious cycle of rising spreads, contracting liquidity, flights to quality and deterioration of profits.

This is a story of groups that have worked to reverse this adverse trend. By saving private intermediation, rekindling the competitive fires under markets and generating new liquidity sources, there is hope that greed and competition will regain their prior virtues and support a return to real economic growth.

RISING RATES REDUCE VALUES

The present cost of long-term debt for highly rated companies is about the same as it was in 1998. Within the past year, relative funding cost for unrated firms had risen to as much as 5.2% over 1998 levels.

For investors, higher risk is reflected in market rates and justifies higher spread. All else being equal, however, rising spread means the market value of existing financial assets will certainly fall. At the end of 2000, a 10-year non-investment grade financial asset originated in early 1998 would be worth about 91.5% of its original value based on the new indicated spread.

By the end of 2000, when the US Federal Reserve System began to aggressively lower short-term rates, spreads were 120 basis points above the panic levels seen in the fall of 1998. For affected businesses, the consequence was a huge increase in the cost of raising long-term debt. A 10-year promise of repayment which would yield $100 for a borrower to deploy in operations early in 1998 would only provide about $63 as 2001 began. No wonder the US has seen a contraction in the demand for capital goods.

When investors demand higher spread, a decline of business profit almost certainly follows. A recent Business Week article describes revisions of US Commerce Department data on business profits during the last half of the 1990s. The revisions include tax return figures for smaller firms. The new data shows that corporate profits actually began a downward trend in 1998, about the time Figure 1 shows that spread started to widen. By the first quarter of 2001, new figures show "the profitability of nonfinancial companies ... is at its lowest level since 1993, suggesting that margins are under extreme pressure" (August 27 2001, page 43).

Can rising spreads be reversed before the US economy falls into a liquidity trap and drags the world into a recession?

Yes, and the solutions needed may be coming out just in the nick of time.

The key to narrowing spreads is to create low-risk liquidity and more competition in finance. The proven way to do that is by securitization, private intermediation of financial assets. This allows firms that are facing difficult debt markets to sell financial assets free of the operational dangers that rising spreads and narrowing margins have created for the selling firms.

To be effective, securitization must be grounded on sound rules and equally available to all participants. During the past four years, basic US rules on securitization have undergone a thorough review. New and improved rules are now in place and may open the way to economic recovery.

Here's the story.

WHEN IS A FINANCIAL ASSET SOLD?

Financial statements of investors should reflect the financial assets they own, and no more. Otherwise, significant distortions can (and will) occur. Regulatory capital rules, calculations of return on assets, leverage ratios and other factors by which we measure the success or failure of a financial enterprise all depend on defining when, precisely, interests in financial assets are transferred.

Due to the nature of money, mistakes regarding the reporting of financial asset ownership compound rapidly. Financial statements of a bank quickly become misleading if it reflects assets on its balance sheet which have been sold. With insured deposits, assets that are sold, but incorrectly shown on the balance sheet, still appear as supporting deposits, to the detriment of deposit insurance funds.

It is equally misleading to reflect assets as sold when they are, in fact, owned by a selling bank. In this case, capital requirements are evaded, and monetary aggregates understated, to the detriment of sound monetary and regulatory policy.

For all its importance, however, it is very hard to define precisely what it is that distinguishes a loan secured by financial assets from a sale of the same assets. This should not be a surprise. There is no economic difference between these transactions.

The parties do not change just because the label for their transaction changes from sale to loan or vice versa. The market in which their negotiations occur does not change and the financial assets which support the transaction do not change. For every risk that is passed or retained, by the mathematical certainty of (1 + i)x there will be a precisely equal and offsetting reward.

Yet the daily accounting reflection of trillions of investment dollars is determined by a line that must divide sales from secured debts. In the US, experts have struggled with this dilemma since we began to allow banks to borrow money on a secured basis. September 2001 appears to mark the point at which market participants finally united behind new sale principles that can create a lasting and usable definition for all concerned.

To understand how we arrived at this point, it is necessary to review the history of sale rules. From the early 1970s to the early 1980s, asset securitization structures developed in the US with little in the way of fundamental accounting guidance on when a sale occurred. By 1983, the Financial Accounting Standards Board (FASB) analyzed practices which developed in the mortgage-backed securities business and found two basic forms: (i) pay-through bonds sold by non-consolidated financial affiliates of industrial firms; and (ii) pass-through securities issued by financial enterprises.

The first structure was a secured debt, the second was a sale. The feature that distinguished them was form. The FASB applied form as the basis for defining a sale under SFAS 77 (adopted in 1983).

SFAS 77 was based on the premise that, if a transaction purports to be a sale, it should be accounted for as such. Bank regulators, however, continued to apply regulatory accounting policies distinguishing transactions based on retention of recourse (to assets but not future earnings).

SFAS 77 soon began to be criticized: "How can we say something's a sale just because it purports to be a sale?"

For all its theoretical flaws, SFAS 77 was an enormous economic success. The period from 1983 to 1996 (SFAS 125 replaced SFAS 77 at the end of 1996) saw a virtual explosion of asset securitization structures. Some transactions exalted form over substance and were justly criticized. Many, many other transactions, however, were well founded and produced enormous economic benefits.

Under SFAS 77, the US broke loose from the limits on intermediation that accompany bank regulation. Almost by necessity, regulated banking places safety and soundness ahead of innovation. While SFAS 77 was in effect, innovations in private intermediation (the ability to transfer financial assets between investors directly, without the intervention or monetary policy implications of regulated banking) brought securitization from infancy to a model that rightly became the envy of the financial world.

As is often the case in financial markets, however, actual or perceived abuses of the standard (purports to be a sale) led to the need for a new standard. While form was acceptable for a developing market, the FASB recognized the need to seek an improved basis to distinguish sales from secured loans. Moreover, Congress had directed regulators to apply GAAP principles to banks in 1989. A new standard would hopefully satisfy the needs of both banks and non-banks.

The search for this new standard began as the US was extracting itself from the financial debacle of the 1980s bubble. The FASB learned that rating agencies had developed rules based on a concept of legal isolation. Legal isolation assured that financial assets are so far separated from the selling enterprise that they could not be recovered even in bankruptcy or receivership of the seller.

This standard proved sound for determining when assets could be separated from an entity, pooled and rated independent of the rating of the seller. It had survived the test of a recession in the early 1990s. Isolation is, however, a standard which sometimes baffles even lawyers who are experts in bankruptcy and receivership law.

Precisely what must be done to isolate assets beyond the reach of a receiver or a court in bankruptcy? Bankruptcy courts have power to recharacterize transactions to reflect the true intent of parties. They are, moreover, charged with balancing the interests of all creditors and investors in the insolvency proceedings. To distinguish a sale from a secured debt, bankruptcy courts must decide whether a transaction, though in the form of a sale, is, in fact, an equitable mortgage.

For as long as there have been secured loans, lenders have sought (largely without success) to retain both the ability to sell collateral at their unfettered discretion and to hold debtors liable for whatever remains unpaid when the sale is complete. For an equal period, debtors have sought to preclude foreclosure abuses by creditors. Courts and legislators have created principles designed to protect both sides from destroying an economy in the course of this never-ending battle.

A sale becomes an equitable mortgage when a court, in equity, determines that the seller is obligated (in the manner of a debtor) and should be entitled (at a minimum) to redeem affected assets by repaying the debt before the assets are sold to bona fide purchasers. For enterprises affected by US bankruptcy laws, the one sure means to achieve a sale where the buyer wants some form of recourse has been by clear avoidance of the equitable mortgage doctrine.

Avoidance is achieved by placing assets in a separate and distinct wholly-owned subsidiary of a selling firm that is designed to make remote the possibility of bankruptcy or other receivership. Financial assets are contributed by the parent to the subsidiary in exchange for cash and equity. As a consequence, the transferring entity is assured receipt of fair value (cash plus equity). If the subsidiary is limited in its activity solely to transactions which will not result in its own bankruptcy, investors can generally engage in sale or loan transactions with the subsidiary and remain isolated from concern over bankruptcy of the selling entity.

The capacity of this structure to achieve legal isolation was adopted as the fundamental standard for sale treatment by the FASB in 1996 (SFAS 125, par. 9(a)), effective January 1 1997. Bank regulators quickly adopted SFAS 125 for bank transactions at the end of 1996. However, banks soon had to be exempted from the legal isolation test when the FASB learned it had not properly understood the Federal Deposit Insurance Corporation's (FDIC) powers, as receiver, to repudiate any contract of a bank as of the date of receivership.

Legal isolation remains the foundation of the FASB's new standard, SFAS 140, which became effective for non-bank transactions after March 31 2001. With the FDIC's creation of a regulation that exempts conforming securitizations from repudiation (and one last amendment of SFAS 140), legal isolation will finally apply to bank transactions after December 31 of this year (June 30 2006, in the case of certain existing structures).

While complex, isolation creates the robust standard for sale that the FASB sought to replace SFAS 77. Moreover, with identical standards now applicable to banks and non-banks, it appears that uniform GAAP accounting, a goal which Congress established in 1989, will finally be achieved as of January 1 2002.

HOW IS COMPLIANCE WITH LEGAL ISOLATION TESTED?

As an accounting standard, SFAS 125 requires that there be reasonable assurance that the legal isolation test is met in order to accept management's asserted treatment of a transfer of financial assets as a sale. The existence of reasonable assurance is a matter for audit guidance, however, within the purview of the Auditing Standards Board (ASB).

In 1997, a task force was appointed under the auspices of the ASB to draft the requisite guidance. Early in 1998, based on the report of that task force, the ASB issued AU Section 9336, which set forth guidance on what auditors should obtain and review in the way of legal interpretations to determine whether reasonable assurance of legal isolation had been achieved. That guidance, however, did not include banks.

The FASB's waiver of isolation for banks (in the autumn of 1997) was designed to allow the FASB, the ASB and the FDIC to conduct further study. That study led to numerous changes, including a remarkable FDIC regulation that will be discussed later in this article. Following adoption of the FDIC's regulation, the FASB adopted SFAS 140 and FASB Technical Bulletin 01-1 (July 23 2001, FTB 01-1). That completed the accounting guidance for bank isolation.

By the end of September 2001, it is hoped that the ASB will approve and publish a restatement of AU Section 9336. A draft statement has been circulated to the ASB for its approval. The new guidance reflects changes in accounting guidance that have occurred since 1998.

With restatement of AU Section 9336, accounting and auditing literature for the new US sale standard will be complete. This is a significant step forward for regaining balance in US financial markets. The new audit guidance summarizes terms of legal opinions which lawyers for banks that wish sale treatment are expected to provide after December 31 2001. While stated differently, the opinion confirms the same level of legal isolation will exist for banks as for non-banks.

RESTATEMENT OF AU SECTION 9336

If approved by the ASB, the proposed restatement of AU Section 9336 will be published on the website of the American Institute of Certified Public Accountants. It will also be published in the Journal of Accountancy.

Those initial publications will indicate, by bold italics and strike-through, each modification from the guidance published previously. These changes will not be highlighted as the restatement of AU Section 9336 becomes part of standard auditing literature. Therefore, the initial version will be helpful to show the effects of SFAS 140, and other rules, on prior guidance.

Most revisions of the audit guidance relate to opinions that will be required in connection with sales of financial assets by banks. There are also many statements in the guidance regarding other modifications that affect all securitization transactions. For example, paragraph .10 of the guidance alerts auditors to issues regarding adequacy of consideration when the first step of a two-step transfer is to an entity that is not a wholly-owned subsidiary of the selling corporation.

Under the new standard, all sale is divided into three parts:

1. Transfers with no continuing involvement. Footnote 4 of the audit guidance explains this:

"FASB Emerging Issues Task Force Topic No. D-99 ... characterizes no continuing involvement with the transferred assets as 'no servicing responsibilities, no participation in future cash flows, no recourse obligations other than standard representations and warranties that the financial assets transferred met the delivery requirements under the arrangement, no further involvement of any kind'".

2. Transfers to third parties where an opinion meets the standards of the audit guidance (generally paragraph .13 or .14), there is no restraint on resale or pledge of the assets transferred (9(b) of SFAS 140) and there is no repurchase agreement or "unilateral ability" of the transferor to reclaim the transferred assets (9(c) of SFAS 140).

3. Transfers, often in the form of securitizations described in paragraphs 83 and 84 of SFAS 140, done in one or more steps (taken as a whole) where: (i) there is an opinion meeting the guidance; (ii) any intermediary entities (between the transferring entity and investors or entities controlled by third parties) are either "qualifying SPEs" (meeting the tests of SFAS 140) or bankruptcy remote consolidated affiliates of the transferor described in the last sentence of paragraph 27 of SFAS 140; (iii) third parties get whole or partial interests in the assets, or beneficial interests, that can be pledged or exchanged (at least with consent that will not be unreasonably withheld by the transferor) (9(b) of SFAS 140); (iv) there is no repurchase agreement or offending call (9(c) of SFAS 140); and (v) the initial transferring entity does not have redemption rights, though a bankruptcy remote consolidated affiliate of the transferor that meets the tests of the last sentence of paragraph 27 of SFAS 140 can have redemption rights (see FTB 01-1).

Banks, if they meet the transfer standard of the FDIC regulation (12 CFR 360.6) and don't hold redemption rights, and certain other entities not subject to the US Bankruptcy Code have the additional capacity to pass partial interests directly to third parties or to trusts where the transferor retains residual interests. These transactions are allowed by paragraph 84 of SFAS 140, provided they are supported by the requisite opinions.

EFFECT ON SECURITIZATION

The new standard should boost private intermediation. With two exceptions (and minor corrections to some servicing agreements), all existing securitization practices permitted by SFAS 125 survive. The effect of all this is strong support for the traditional process of securitization in US markets, primarily relying upon true sales/contributions of assets to wholly-owned special purpose subsidiaries. The exceptions, moreover, will not limit this vital source of systemic liquidity for US financial markets.

The two exceptions are:

A. Removal of accounts/repurchases of transferred assets: Procedures under SFAS 125 which had allowed transferors to cause the return of assets must not be exercisable under SFAS 140 without the actions (or failure to act) of another party. The other party cannot be an affiliate or agent of the transferor (the person whose actions are required cannot be someone that is effectively dependent on the transferor or its affiliates for support in the transaction). Actions that must be taken by underlying obligors, market events and independent buyers or investors seem acceptable. Random selections may also work in some cases.

B. Redemption rights: Bank structures that relied on creating master trusts that were, in fact, equitable mortgages of bank assets need revision for existing trusts by no later than June 30 2006. No transfers by non-banks can create redemption rights of the transferor itself or its consolidated affiliates (other than those that are designed to make remote the possibility of bankruptcy or other receivership). For banks, new securitizations completed after December 31 2001, cannot have offending characteristics of equitable mortgages and must be supported by opinions meeting paragraph .14 of the audit guidance. Either of two methods appears to satisfy this new standard for banks. Banks with securitizations that create redemption rights can modify terms of documents to eliminate redemption rights. Alternatively, structures can be revised to put redemption rights in a bankruptcy remote affiliate of the transferring bank. Both alternatives appear feasible and attainable.

The result of SFAS 140 and the audit guidance is that all securitization market participants, banks and non-banks, will have identical access to capital markets for the sale of financial assets. This creates a level playing field for securitization, replacing a two-tier market where only banks obtained sale treatment for equitable mortgages.

In modern markets, competitive advantage creates a market imbalance that can drive disadvantaged participants out of the market. Eventually, that would increase funding costs for every disadvantaged firm.

Implementation of SFAS 140, FTB 01-1, the audit guidance, and other anticipated measures to support market recovery should help to resolve liquidity concerns in which many US non-financial firms now find themselves. Hopefully, these measures not have arrived too late.

Banks will continue to enjoy certain alternative securitization methods that are not available to entities subject to the US Bankruptcy Code. This is the result of legal differences between banks and non-banks, however, not mere accountancy. Legal advantages for banks are accompanied by regulatory constraints that do not affect non-banks.

If this new balance works, greed and competition may re-create the virtuous cycle which boosted US markets in the 1990s. From 1992 to 1998, traders bid down spread as they profited by creating additional means to liquefy financial assets at lower spreads that reflect, in turn, the lower liquidity risk fostered by their success.

BANK OPINION REQUIREMENTS

The audit guidance provides the following examples for sale opinions that bank counsel will be asked to deliver for transactions occurring on and after January 1 2002.

Example 1: "We believe (or it is our opinion) that in a properly presented and argued case, as a legal matter, in the event the Seller were to become subject to receivership or conservatorship, the transfer of the Financial Assets from the Seller to the Purchaser would be considered to be a sale (or a true sale) of the Financial Assets from the Seller to the Purchaser and not a loan and, accordingly, the Financial Assets and the proceeds thereof transferred to the Purchaser by the Seller in accordance with the Purchase Agreement would not be deemed to be property of, or subject to repudiation, reclamation, recovery, or recharacterization by, the receiver or conservator appointed with respect to the Seller." (Note: When the opinion indicates that isolation is achieved without reference to a true sale, the opinion also should provide reasonable assurance that the transferred assets are beyond the reach of the transferor and its creditors other than the transferee to the same extent that is provided in example 2 paragraph B.)

Example 2: "The Federal Deposit Insurance Corporation has issued a regulation, 'Treatment by the Federal Deposit Insurance Corporation as Conservator or Receiver of Financial Assets Transferred by an Insured Depository Institution in Connection with a Securitization or Participation,' 12 CFR section 360.6 (the Rule). Based on and subject to the discussion, assumptions, and qualifications herein, it is our opinion that:

A. Following the appointment of the FDIC as the conservator or receiver for the Bank:

(i) The Rule will apply to the Transfers,

(ii) Under the Rule, the FDIC acting as conservator or receiver for the Bank could not, by exercise of its authority to disaffirm or repudiate contracts under 12 USC §1821(e), reclaim or recover the Transferred Assets from the Issuer or recharacterize the Transferred Assets as property of the Bank or of the conservatorship or receivership for the Bank,

(iii) Neither the FDIC (acting for itself as a creditor or as representative of the Bank or its shareholders or creditors) nor any creditor of the Bank would have the right, under any bankruptcy or insolvency law applicable in the conservatorship or receivership of the Bank, to avoid the Transfers, to recover the Transferred Assets, or to require the Transferred Assets to be turned over to the FDIC or such creditor, and

(iv) There is no other power exercisable by the FDIC as conservator or receiver for the Bank that would permit the FDIC as such conservator or receiver to reclaim or recover the Transferred Assets from the Issuer, or to recharacterize the Transferred Assets as property of the Bank or of the conservatorship or receivership for the Bank;

provided, however, that we offer no opinion as to whether, in receivership, the FDIC or any creditor of the Bank may take any such actions if the Holders [holders of beneficial interests in the transferred assets] receive payment of the principal amount of the Interests and the interest earned thereon (at the contractual yield) through the date the Holders are so paid; and

B. Prior to the appointment of the FDIC as conservator or receiver for the Bank, the Bank and its other creditors would not have the right to reclaim or recover the Transferred Assets from the Issuer, except by the exercise of a contractual provision [insert appropriate citation] to require the transfer, or return, of the Transferred Assets that exists solely as a result of the contract between the Bank and the Issuer... ."

(Note: Paragraph B is not required if the opinion includes both a conclusion, as set forth in example 1, that the transfer constitutes a "true sale" and the conclusions set forth in paragraph A of example 2. It is not necessary to include any provision of example 2 if the opinion is as set forth in example 1.)

Where the opinion does not otherwise cover "substantive consolidation", an opinion on that issue which is roughly the same as has been required for non-banks since 1998 is also included in the audit guidance. In addition to these examples, the guidance indicates how parts of each example may be combined.

THE FDIC'S REGULATION

The final provision of paragraph .14 in the audit guidance explains how certain opinions relate to the FDIC's regulation. Opinions on the ability to overcome the FDIC's power to repudiate any contract may be rendered in reliance on the regulation adopted by the FDIC:

"Certain powers to repudiate contracts, recover, reclaim, or recharacterize transferred assets as property of a transferor that are exercisable by the FDIC under the Federal Deposit Insurance Act may, as of the date of the transfer, be limited by a regulation that may be repealed or amended only in respect of transfers occurring on or after the effective date of such repeal or amendment. With respect to the powers of a receiver or conservator that may not be exercised under that regulation, it is acceptable for attorneys to rely upon the effectiveness of the limitation on such powers set forth in the applicable regulation, provided that the attorney states, based on reasonable assumptions, that: (1) the affected transfer of financial assets meets all qualification requirements of the regulation and (2) the regulation had not, as of the date of the opinion, been amended, repealed, or held inapplicable by a court with jurisdiction with respect to such transfer. The opinion should separately address any powers of repudiation, recovery, reclamation, or recharacterization exercisable by a receiver or conservator notwithstanding that regulation (for example, rights, powers, or remedies regarding transfers specifically excluded from the regulation) in a manner that provides the same level of assurance as would be provided in the case of opinions that conform with requirements of paragraph .13, except that such opinion shall address powers arising under the Federal Deposit Insurance Act. The considerations in the immediately preceding three sentences are adequately addressed either by the example 1 opinion or the example 2 opinion described in this paragraph or by the variations described in footnotes 10 ...". (Note: The applicable regulation is 12 CFR section 360.6, effective September 11 2000.)

The FDIC's regulation was the key that allowed banks to meet the isolation test and the FASB to complete SFAS 140. Adoption of this regulation was a vote of confidence in US secondary markets and represents, perhaps, final recognition by bank regulators that free financial markets will, over time, consistently outperform controlled markets.

Markets were contracting as this regulation was debated, and the FDIC suffered at least one significant loss as a result of a bank's abuse of securitization (apparently by reporting sold assets as retained). The agency nevertheless adopted a regulation waiving the right to repudiate specific securitization contracts in receivership proceedings. Moreover, the FDIC agreed not to amend or revoke the regulation with retroactive effect.

The regulation is a remarkable achievement. The FDIC's regulation precludes application of principles that have been applied, in one form or another, since the dawn of bank insolvency proceedings. The ability of governments to repudiate contracts between their banks and citizens upon insolvency of a bank has permitted governments to overrule private market practices in favour of government control. Government's interest in maximizing recoveries on bank insolvency outweighed those of parties that contracted with the bank while it operated. For conforming securitizations, the regulation reverses this doctrine.

By adopting this regulation, FDIC recognizes that the liquidity which securitization offers to healthy banks far outweighs any benefit the FDIC might recognize if it chose to repudiate conforming securitization contracts in receivership. By setting requirements for transactions that avoid repudiation, and permitting prospective amendment of the regulation, the FDIC preserves its ability to assure continuing safety and soundness of future securitization procedures used by insured US banks, while protecting those who will invest in reliance on the regulation.

WHY SAVE PRIVATE INTERMEDIATION?

The effort to regain parity between bank and non-bank securitization practices took more than four years. Figure 1 shows that those have been tough years for financial intermediation.

In 1998, private intermediation became disadvantaged by the combined impact of advantages that had to be accorded to banks under accounting rules and intentional implementation of US Securities and Exchange Commission (SEC) rules that restricted access to money market funds for several types of very liquid and highly diversified securitization products. The rise in the relative cost of long-term funds for most businesses can be fully explained by analyzing the logical implications of these policies.

When markets are well structured, greed and competition assure efficiency, because efficiency rewards greed when competition exists. When intermediation is restricted, or tilted in favour of particular competitors, short-term profits and oligopolistic behaviour can combine to permit greed and restraint to create inefficiency and higher funding cost for all businesses that are out of favour.

Since money is fungible and infinitely replicable, when financial markets are restricted or tilted everyone suffers by the consequences of reduced activity and lower asset values. A few investors may gain short-term profits on rising spreads. For all others, portfolio values will fall in lock-step with rising spread. Since finance mirrors the value of non-financial assets, declining financial asset values eventually result in declining values for investors and for non-financial assets. To reverse these trends, private intermediation must be saved.

In one presentation, a prominent bank lawyer noted that the fate of the US banking system "hung in the balance" for nearly four years while the FASB, the FDIC and the ASB debated and resolved means by which banks can intermediate assets under SFAS 140's isolation standard. That was an understatement.

Far more was at stake. Competitive balance of all US financial markets was at issue. It has been noted that private intermediation accounts for more than two-thirds of all US financial transactions. If banks gained a permanent competitive advantage over private intermediation merely by accountancy, eventually only banks would intermediate assets.

No system can afford to lose two-thirds of its financial markets. Since US markets account for nearly 80% of worldwide financial intermediation, moreover, worldwide consequences of failing to save private intermediation in US markets are almost incomprehensible.

THE ONCE AND FUTURE US MARKET

The new US sale standard represents an enormous accomplishment on the part of the FASB and its staff.

Financial markets which produced the "Goldilocks Economy" of 1993 to 1998 can be regained, even in times of political crisis. Most of the necessary guidance is in place. Practitioners must understand the rules and implement them wisely.

The ultimate test for sale treatment under SFAS 140 will likely be the existence of redemption rights. The FASB's July 23 2001, Technical Bulletin 01-1 makes it clear that sale treatment is not available where there are equitable rights of redemption that exist in the hands of selling entities. Such rights may only exist in consolidated affiliates of transferors that are, in the words of paragraph 27 of SFAS 140, "designed to make remote the possibility" of bankruptcy or receivership.

Since recourse, plus the ability to access transferred assets, can create an equitable right of redemption, it is this intersection of law, economics and accounting that will likely become the focal point of concern for market structures.

There are other existing and proposed market restraints which should also be resolved to boost the chance for a quick economic recovery. The SEC's 1998 amendments to Rule 2a-7 should be clarified to eliminate inappropriate application of the large obligor rule to well-diversified and highly liquid securitized investments. The Federal Reserve Board's recently proposed Regulation W (which regulates bank compliance with laws restricting transactions with affiliates) should be amended to exempt appropriate securitization structures that assure bank liquidity without creating opportunities for systemic abuse.

Care must be taken to preserve private intermediation whenever we consider laws (and regulations) affecting bankruptcy, securities trading and relations between debtors and creditors. Such rules must not inadvertently interfere with the free flow of capital from those that have it to those that will most efficiently use it.

Private intermediation is essential to assure participants in US financial markets that their cost of funds accurately reflects investment risk and minimizes cost associated with market intervention risk that precludes efficient means for realizing the value of investments.

Saving private intermediation was not just important, it was fundamental to the vitality of US financial markets, the main transfer point of the world's collective economic future.


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