December 23, 2001


Are New Woes Lurking in Financial Nether World?



The Associated Press

The collapse of Enron, which laid off Meredith Stewart, above, and thousands of others, has left investors skeptical of other companies.



Say no attention to those liabilities behind the curtain.


That is the message corporate America has sent to investors in recent years as executives have shunted billions of dollars in new and existing financial obligations off their books and into the nether world known as "off the balance sheet."


When the stock market roared, investors were only too happy to believe that what they didn't know about their company's true financial picture couldn't hurt them. But now, in a crestfallen market reverberating with shock waves from Enron (news/quote)'s collapse, shareholders are realizing that just because an obligation is absent from a company's balance sheet does not mean that it can't come back to bite them.


What occurred at the Enron Corporation, at considerable distance from the assets and liabilities on its balance sheet, may of course prove an anomaly. The company, now in bankruptcy but once the world's dominant energy trader, was an aggressive user of partnerships separated from the parent but for which the parent's shareholders remained on the hook. Perhaps worse, it also committed the ultimate sin of omission — it failed to disclose the extent of its contingent liabilities related to those partnerships. Under federal securities laws, those details should probably have been listed in at least the footnotes to the company's financial statements.


In itself, off-balance-sheet financing is no vice. Companies can use it in perfectly legitimate ways that carry little risk to shareholders. The trouble is, while more companies are relying on off-balance-sheet methods to finance their operations, investors are usually unaware that a company with a clean balance sheet may be loaded with debt — until it is too late.


"One intent of these structures is to try to move debt off the radar screen so that companies appear less financially leveraged than they actually are," said Scott Sprinzen, co-chairman of the corporate bond rating criteria committee at Standard & Poor's. "We try to reflect these off-balance-sheet obligations in our assessments. But if someone was just to take the financial statements at face value and not delve very deeply into these arrangements, then the statements could be misunderstood."


During the last decade, thousands of companies in many industries have used off-balance-sheet financing to power their expansions. Their obligations range from the mundane — payments on leased aircraft or on real estate that is owned by third parties or liabilities associated with operations in which a company has a minority interest — to the more arcane, including complex derivatives transactions.


The most aggressive users of off- balance-sheet financing are, not surprisingly, financial services businesses like banks and brokerage firms. But retailers, airline companies, automakers and even gambling concerns use these financing techniques.


Each publishes their liabilities — or not — pretty much as they see fit.



With the boom phase of the economic cycle over, it is especially crucial for shareholders to have a complete grasp of a company's leverage. Banks and other lenders are no longer in the mood to offer companies easy money; some have reduced their appetite for lending or have chosen not to roll over existing debt. Unseen obligations at companies can destroy shareholders' wealth faster than the weather changes in Maine. Descents like Enron's are not called "death spirals" for nothing: it took less than a week after a credit rating downgrade for the company to file for bankruptcy protection.


These days, then, the aggressive use of off-balance-sheet financing is especially dangerous, said Sean J. Egan, managing director at Egan- Jones Ratings, a Wynnewood, Pa., credit rating firm that, unlike Moody's (news/quote) and Standard & Poor's, the biggest agencies, is not compensated by the issuers whose debt it assesses.


"Companies are in much worse shape now than they were maybe three years ago — their balance sheets, their income statements," he said. "There are some egregious examples of companies like Enron that are rapidly growing and attempting to shield their growth in leverage from the market. With the increased volatility in the market, they are getting into difficulty."


One straw in this increasingly turbulent wind can be found at the major ratings agencies: the number of downgrades they assign to corporate bonds, compared with upgrades. Based on data through Dec. 17, Moody's Investors Service has downgraded 616 bond issues this year, well above the 2000 count of 472. This year, for every upgrade, 2.88 bonds have been downgraded — versus 2.26 last year.


The current number is the highest since 1991, the last recession, when it reached 2.93 (though it is well below the 4.39 in 1990).

Because disclosure is so spotty, it is hard to determine exactly how much debt resides off the balance sheet at American companies — and at which companies. But many bond market experts agree that the explosive growth in this method of financing has occurred over the last 20 years and is a result of Wall Street ingenuity as well as changes in the way Americans finance their buying.


Decades ago, for example, airlines typically owned their planes, but today most lease them through arrangements with leasing companies, often off the balance sheet. While these arrangements allow airline companies to borrow less, they also mean that airlines have fewer assets to sell if they need to raise money.


Consumers have also contributed to the growth in off-balance-sheet financing. Many more Americans use credit cards today than they did just two decades ago. But banks and other credit companies do not want to carry those borrowings on their books. Instead, they have found ways to bundle small loans and to "securitize" them, selling them to subsidiaries, unrelated companies or institutional investors.


Carol Levenson, the editor of Gimme Credit, an investment advisory newsletter in Chicago that focuses on high-grade bonds, said the nature of these financing techniques had changed recently.


"There has been off-balance-sheet project financing and even acquisition financing for years," she explained, but it usually left the parent company unexposed. "It seems to me what's changed in recent years is the contingent obligation of the parent."


Indeed, in the old days, certainly before the last recession, if an obligation was moved off a company's balance sheet it was usually because the company had no liability whatsoever for the debt.



But in today's loosey-goosey world of financial statements, off-balance-sheet obligations include those that keep a company exposed to some liability. Today's definition of off-balance-sheet financing has been stretched in much the same way the definition of earnings has — with individual companies deciding what expenses they will count, or not, in "pro forma" earnings.


"For debt to be considered truly off balance sheet, there would have to be full and complete risk transference," said Pamela Stumpp, chief credit officer at Moody's Investor Service. "If there is any hook to the parent or if the parent is liable for any aspect of the operation, then it might not be a true off-balance-sheet liability."


Yet, as the Enron case showed, liabilities can remain on companies' books.


Investors, meanwhile, have been kept in the dark, Ms. Stumpp said, because many companies have not disclosed the details of the liabilities. For example, management at Calpine (news/quote), a seller and trader of energy, has not disclosed in filings the existence of a $300 million letter of credit facility arranged with Credit Suisse First Boston in late August. The letter of credit was revealed by a Moody's analyst who downgraded the company's debt to junk status on Dec. 14.


A Calpine spokesman said that because the $300 million was not drawn, it did not constitute indebtedness. The company's securities counsel has stated that it was not required to be reflected in Calpine's periodic reports.


But that is emblematic of what Ms. Stumpp criticizes. "Financial officers are increasingly making judgment calls as to what to include about these things in the financials," she said. "Certain off-balance-sheet obligations are not included in disclosure. There is a need for better disclosure to clarify these structures because clearly there is risk that needs to be assessed in connection with them."


After a debacle like Enron's, regulators may begin to examine disclosure lapses. Analysts and investors, meanwhile, are scrambling to understand where the fault lines are; Enron, whose shares trade for 53 cents, demonstrated how risky off-balance- sheet deals can be for shareholders.


Understanding that risk is not easy. Off-balance-sheet financings, even when disclosed, are highly arcane and can vary considerably, even at the same company.


Assessing the risk of something even as plain vanilla as financing of auto loans is problematic for investors. Ford Motor (news/quote), for example, carries only $12 billion in debt on its balance sheet, 14 percent of its assets. But in the third quarter, Ford Motor Credit held $40 billion in operating leases. They are backed by the cars that Ford has leased, but in a distressed situation, it is not clear that those assets would have enough value to pay off the loans.


Essentially, companies assess their risk themselves, and Walter P. Schuetze, former chief accountant to the Securities and Exchange Commission and chief accountant of its enforcement division, expressed fears that companies are not pricing their retained risks properly. "Consequently, we are getting overstated gains and understated losses when the paper is sold and periodically thereafter we are getting understated liabilities," said Mr. Schuetze, who is retired but remains a consultant to the commission.


Why does the mispricing occur? The wrong people are in charge of assessing the risks, Mr. Schuetze said. "The reporting enterprise or company is setting those numbers, and auditors look at them and say, `That's about right,' " he said. "The enterprise should not be making that determination, and the auditor doesn't have the expertise to make that determination. It should be made by someone outside the reporting enterprise who is a competent expert." Then, Mr. Schuetze said, the expert's opinion should be included in company filings with the S.E.C.


As off-balance-sheet financing techniques have grown in popularity — and imagination — several areas appear especially perilous, according to corporate bond experts. The use of special-purpose vehicles, like those at Enron that housed the partnerships and benefited certain insiders — but for which the shareholders were ultimately liable — is particularly troublesome as a result of Enron's failure.


Glenn E. Reynolds, chief executive of Credit Sights, an independent credit analysis firm in New York, said special-purpose vehicles were common at brokerage firms. In most of them, Mr. Reynolds said, the assets are unidentified and the risks unfathomable.



In a typical setup, a brokerage firm creates an unregulated subsidiary specifically to hold a high- risk asset — such as debt issued by an emerging-market country like Argentina. The firm then makes a loan backed by the asset to a special- purpose vehicle that is off the brokerage firm's balance sheet. Because the subsidiary is unregulated, it may not have to record changes in the asset's value, known as marking to market. But if the asset defaulted, it would have to be marked to market and could cause repayment on the loan made to the special-purpose vehicle.


The problem with these transactions, Mr. Reynolds said, is "you just don't see transparently the risk portfolio."


"If it blows up," he said, "then it sees the light of day. Until then, the fact there's a bomb down there is not so obvious to the outside investor."


Other lending arrangements that are used to minimize debt can also become a problem for a company, especially if it loses the confidence of investors. At any company with a trading business — Enron was one, but other merchant energy companies include the Williams Companies (news/quote), Calpine and Dynegy (news/quote) — the brokerage firms or banks financing their trades may ask for additional collateral if they start to lose confidence in the companies' abilities to raise money in the capital markets. Such a reeling in of credit would not be seen by outsiders, but it could cause a squeeze if the company had little cash on hand, or access to it. That is why Enron drew down all of its credit lines, $3.3 billion, as soon as trouble loomed.


"A big difference today from 1991 is how extremely powerful global financial institutions have generated huge credit lines with these companies," Mr. Reynolds said. These credit lines, which can be generous in good times, can be withdrawn in a matter of hours if a problem surfaces, he pointed out.


Other off-balance-sheet arrangements back complex transactions designed to insure institutional investors' holdings. Known as credit derivatives, they had a notional value of $360 billion in the third quarter of 2001 and are a fast-growing segment of the overall derivatives market, rising 60 percent annually since late 1997, according to David Hendler, financial company strategist at Credit Sights. "The top seven banks control 97 percent of all the derivative trades in the United States," he said. The exposure of J. P. Morgan Chase (news/quote), he added, stands at more than three times the bank's tangible equity.


Yet the risks associated with derivatives trades have never been tested in a sour economy; their consequences are unknown.


NY company, not just a bank, can have obscured risks. One involves corporate bonds held in the issuing company's Employee Stock Ownership Plan. Known as ESOP notes, they often carry features that require the company to pay back the bonds if its credit rating falls below investment grade.


Armstrong World Industries (news/quote), a subsidiary of Armstrong Holdings, a maker of floor coverings and cabinets, filed for bankruptcy protection a year ago. The company had $142 million outstanding in ESOP bonds at the time. When Armstrong's credit rating fell to below investment grade, the company had to repay the bonds.


But Mr. Reynolds said these stipulations seldom showed up anywhere in filings, even in the footnotes to the financial statements. "Armstrong's was not even included in its detail debt footnote on ESOP notes at year- end," he said. "These details typically do not get disclosed unless the crisis is upon you."


Almost everyone agrees that companies must disclose more details about their off-balance-sheet transactions and entities — and soon. The absence of disclosure, according to Mr. Reynolds, "reflects the abuse of substance in accounting today."


"There is no reason for these things not to be disclosed," he said. "It's just withholding material information. That can lead to shocks, and where there are shocks in the market, it leads to decline in confidence."


Ms. Levenson, the bond analyst, agreed. "I truly believe if Enron had kept all this stuff on the balance sheet and worked it into its maturity schedule just like any other debt, even if it meant carrying a $3 billion higher debt load," she said, "it may not have been a strong triple-B credit but it might still be a going concern today." 






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