Three years after Enron's off-balance-sheet shenanigans gave structured finance a black eye, the market for mind-numbingly complex financial deals with a habit of closing at the end of the quarter is sizzling. This week, the parent companies of Standard & Poor's and Moody's Investors Service both reported higher second-quarter earnings and revenue, in large part due to their ratings work on structured-finance transactions. S&P, which is owned by McGraw-Hill ( MHP), reaped particular rewards from structured finance, part of the category of Wall Street instruments known as derivatives. In a tough market for bonds and new equity issuance, the ratings house saw revenue rise 14.8% from a year ago to $504.5 million, while operating profit shot up 24.9% to $214.2 million. Among the fastest-growing areas of the structured finance market are asset-backed securities, sophisticated financing arrangements that companies and investors use to hedge risk, avoid paying taxes or convert an illiquid investment into cash. Asset-backed securities include a wide range of risk-shifting deals such as credit derivatives, credit default swaps and collateralized debt obligations. Generally, they involve the future cash flow of some asset being bought or sold at a discount in the present. So far this year, Thomson Financial reports, the dollar value of asset-backed securities sold by U.S. companies is up 41% over the same time last year to $444 billion. The number of deals is up 35% to 878. The strong growth in the structured finance market is good news for Wall Street firms such as Citigroup ( C), J.P. Morgan Chase ( JPM) and Lehman Brothers ( LEH), the main dealers in these complicated financings. But the growing demand for structured finance is at odds with the public outcry that followed the collapse of Enron, a company that took the shady art of earnings management to an illegal apotheosis. Andy Fastow, Enron's former CFO, was a master at conjuring sham earnings from asset-backed transactions that could smooth out Enron's earnings and help the company meet Wall Street growth targets.
Fastow's deals were good in a pinch, helping Enron book paper earnings as quarterly deadlines neared. So should investors be worried when S&P observes, as it did Tuesday, that "structured finance repeated its usual quarterly pattern with a surge of activity in the final month of the quarter?" Stephen Ryan, a professor at New York University's Stern School of Business, says it wouldn't surprise him if some element of earnings management were driving the end-of-the-quarter rush. "The biggest piece of structured finance is residential mortgages, and I don't doubt that banks may choose to securitize them with a number of motives in mind, such as risk management, regulatory management and earnings management," says Ryan, a derivatives specialist. But others say there's too fine a line between legitimate monetization and earnings management to draw any definitive conclusions. It's perfectly reasonable for companies to assess the state of their balance sheets when they begin preparing their earnings reports, this camp says. The last month is a natural time for a credit card lender or manufacturer to package together loans or accounts receivable into a bond that can be sold to investors and recorded as a gain on the company's income statement. "Managing your balance sheet at quarter-end seems reasonable," says Janet Tavakoli, a structured finance consultant. A company has "accumulated assets and wants to take a gain and get them off balance sheet. It makes sense to do it later in the quarter, because that's when you've accumulated the most assets." Whether or not the volume of these deals and their timing indicate anything nefarious, Enron's legacy might be about to catch up with the structured finance market. Wall Street bankers are up in arms about a set of proposed federal rules that are aimed at putting the kibosh on structured financings that serve no other purpose than to manipulate profit. The new rules proposed by the Securities and Exchange Commission and bank regulators would require financial institutions to vouch for the accuracy of company's accounting, disclosure and tax treatment for a structured finance deal. Already, banking groups are weighing in with their objections to the new rules, contending that they will increase the cost of structured finance deals and cause companies to shy away from legitimate risk-shifting transactions. In a July 19 letter to the regulatory agencies considering the proposal, The Bond Market Association, the Securities Industry Association and the International Swaps and Derivatives Association said the new rules would "result in significant burdens for participants in these markets." The industry groups contend that the proposal would lead to "new and unwarranted legal exposures for financial institutions." Many on Wall Street also made the same dire predictions when regulators were considering Fin 46, a year-old accounting rule that forces companies to consolidate on their balance sheets any special-purpose entities that don't have enough outside investors in them. Wall Street bankers complained long and loud about Fin 46, the first post-Enron accounting reform to impact the structured finance market. They whined that Fin 46 would have a devastating impact on the asset-backed commercial paper market, which relies heavily on SPEs to arrange short-term financing for companies. A year-old J.P. Morgan Chase research report suggested that Fin 46 might cause the asset-backed commercial paper market, which averages around $723 billion, to decline by as much as 10% in value.
The asset-backed commercial paper market has indeed shrunk since the advent of Fin 46. But at $698 billion, the market is down only 4% from where it was a year ago. While a recent report from S&P blames the new accounting rule for some of the decline, it also attributes some of the slack to a lingering reticence by companies to increase capital spending. "The impact of Fin 46 is not yet clear," S&P notes. "The data from early 2004 suggest it is having an impact, but how big an impact will require a few more months to assess." Meanwhile, S&P expects the asset-backed commercial paper market to rebound in the second half of the year as the economy strengthens and "financing needs for working capital" increase. As is often the case on Wall Street, predictions of doom and gloom about regulatory changes often tend to sound a bit like Chicken Little crying about the sky falling down.