Sometimes molehills can truly become mountains.

A possible change in accounting rules could soon cause some pain for companies that issued a certain type of convertible bond, and for the investment banks that underwrite them. A division of the Financial Accounting Standards Board called the Emerging Issues Task Force (EITF) met Thursday afternoon to decide when and how to change the way companies must account for net share-settlement convertibles.

"The board seems to be extremely interested and has a very strong view on how accounting for these instruments should change," says Hee Lee, a partner at Ernst & Young, whose group consults investment banks.

Typically, convertible securities pay interest, like debt, but give owners the right to convert their holdings into stock under certain conditions. In the net share-settlement variation, companies settle up with investors mostly in cash as opposed to stock, thus avoiding the creation of additional shares.

The accounting for net-share-settlement convertibles "is a sham," Robert Hertz, FASB's Chairman, said in Thursday's meeting, according to two participants.

The FASB could reach a conclusion on the issue as soon as this fall. Accounting experts say the most likely outcome of the new rules is that companies would have to account for the interest expense of the convertible liability as if the security was straight debt.

"Companies will take a big hit to their income statement" if that becomes the case, says Robert Willens, tax and accounting analyst at Lehman Brothers. The rules, if adopted, are expected to be retroactive.

The net share-settlement structure has also has a snazzy tax advantage, which allows the issuer to deduct interest expense at a comparable straight-debt rate. There is no current proposal to change the tax rules on this type of security, though the notion did appear in Congress as a revenue-raiser provision in the Tax Relief Act of 2005.

But "a change in the accounting for these instruments, probably very soon, seems inevitable," says Willens. "This has caused the biggest outcry in the convertible market I can remember."

A FASB rule change would mean that the year's jumbo convertible deals could become giant migraines for the issuers like

Advanced Micro Devices

(AMD) - Get Report

, which issued a $2.2 billion net share-settlement convertible at 6% in late April.

If FASB changes the rule in the way most expect, AMD would have to record on its income statement interest expense for the $2.2 billion based on comparable straight debt, which carries much higher interest costs than its convertible. The company has $600 million of straight debt with a 7.75% coupon also outstanding. At the convertible's 6% annual coupon rate, the annual interest expense on $2.2 billion is $132 million; at 7.75%, the expense jumps to $170.5 million annually.

U.S. Bancorp's

(USB) - Get Report

case is possibly worse. It issued a $3 billion convertible in January with interest of three-month LIBOR minus 1.75%, putting it at about 3.61%. The bank's other nonconvertible, or straight debt, ranges in interest expense from 4.5% to 7.5% for longer-dated debt. At the convertible's rate, interest on the $3 billion borrowing is $108 million annually. At 6%, the midpoint of its straight debt, the annual expense would be $180 million.

Or, take

Countrywide Financial


, which issued a two-part $4 billion deal in May that comes with interest of three month LIBOR, or 5.36% for one portion, and LIBOR minus 3.5%, or 1.86% for a second tranche. With interest running at 5.8% or 6.3% on the company's straight debt, the expense on $2 billion paid at 1.86% jumps to about $116 million from $37.2 million.

As the FASB chips fall, some hedge fund investors say they have been scouring the marketplace to buy up convertibles they believe may be called or bought back at a premium by the issuers if such a rule change were announced, although they didn't specify. If the change goes down as expected, one could reasonably expect some volatility in related stocks.

Representatives of neither AMD, US Bancorp nor Countrywide could be reached for comment late Thursday.

Implications for Investment Banks

The attraction of the net share-settlement convertible is, in part, because it removes one worry associated with traditional converts: the additional stock created when holders convert their holdings. The new stock is a dilutive addition to issuers' outstanding pool of stock.

Year to date, convertible issuance is running at double last year's activity level, and is on pace to set a new record. Thus far this year, the market has absorbed 102 new offerings totaling $50.3 billion, according to Thomson Financial.

The popularity of the net-share convertible has, in turn, boosted its relevance with investment banks and offered large companies cheap ways to raise money with advantageous tax and accounting treatment.

Leading the underwriting of the current convertible bonanza is

Morgan Stanley

(MS) - Get Report

, followed closely by

Deutsche Bank

(DB) - Get Report


J.P. Morgan

(JPM) - Get Report



(C) - Get Report


Bank of America

(BAC) - Get Report

, according to Thomson.

"If enacted, this could deal a significant blow to the health and vibrancy of the convertible market, in our opinion," Merrill Lynch equity analyst Tatyana Hube wrote in March, just ahead of the first EITF meeting on the subject.

Prior accounting rule changes have had the effect of virtually drying up convertible issuance -- at least temporarily.

In 2004, FASB eliminated the favorable accounting methodology for the fad of the day, contingent convertibles called CoCos, which allowed issuers to avoid any dilution to the share pool because certain contingencies had to be met for conversion. Issuance nose-dived after FASB lowered the gavel as corporate CFOs and treasurers lamented the volatility created by the surprise rule change.

Ironically, net share-settlement convertibles were bankers' solution to finding an alternative in a no CoCo world.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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