When I hear or read the words ‘off-balance-sheet financing’ or ‘special purpose vehicle’, warning lights begin to flash and I grab for my obfuscatometer. Off-balance-sheet financing is any form of funding that avoids placing the owners’ equity, liabilities or assets on the balance sheet of a firm or other legal entity. The most common way to achieve this is by placing those items on some other entity’s balance sheet. A standard approach is to create a special purpose vehicle (SPV) and place assets and liabilities on its balance sheet. An SPV is a firm or other legal entity established to perform some narrowly-defined or temporary purpose.
There are circumstances (possibly as many as one percent of the reported occurrences of SPVs), where such entities are created to achieve true efficiency gains. For instance, creating a separate legal entity for certain activities may better align incentives for risk-sharing or may avoid conflict of interest. The overwhelming majority of SPVs are, however, created for nefarious and/or dishonest purposes: evading or avoiding regulation (and associated financial burdens and constraints or reporting obligations); tax avoidance or tax evasion; accounting shenanigans, including the circumvention of ceilings on the budget deficit or debt of public entities; and hiding assets or liabilities from scrutiny by interested parties. These often clever schemes are always economically equivalent to a much more straightforward on-balance-sheet arrangement.
In a recent Comment in the Financial Times, my old friend Professor Luigi Spaventa makes a proposal to mitigate the liquidity crunch, that involves the use of a state-sponsored SPV to purchase illiquid assets from financially distressed private banks. I propose throwing out the SPV bathwater while keeping the liquidity-enhancing baby.
Specifically, in a discussion of the credit crisis and the problem of banks being stuck with large amounts of illiquid assets, Spaventa notes that “Previously unthinkable options are therefore entering the debate, such as the use of public money to acquire all the toxic waste that is polluting banks’ balance sheets. But, even if the worst comes to the worst, does one need to go this far?” He goes on to say that “Some form of public intervention would therefore be required to solve co-ordination problems. Outright purchase of the illiquid credit-based securities in the banks’ portfolio would be neither desirable nor necessary. A publicly sponsored entity could be mandated to issue guaranteed bonds to be offered to banks in exchange for (and with the same maturity as) those assets.”
Spaventa also proposes that the (potentially toxic) assets of the banks be valued at a discount to their face value. This discount should reflect their default risk. They could, for instance, like the Brady bonds issued in exchange for non-performing emerging market debt in 1989, be issued at either par value with a below-market yield, or at a hefty discount and market yield, but those are technicalities.
Assume the SPV has on its balance sheet only the former private bank assets and the bonds it issued to the private banks in exchange for these assets. What Spaventa proposes would have the government receiving an up-front guarantee fee from the SPV and incurring a liability in the form of the contingent obligation to pay the holder of the bonds issued by the SPV in case the former private bank assets are insufficient to meet debt service on the SPV bonds. In an ideal world the guarantee fee and the fair value of the government’s guarantee would be the same. There would be no change in the properly calculated net worth of the government. There also would be no subsidy from the government to the private banks, even though value of what the SPV pays the private banks for their assets exceeds what the private banks could have obtained for these assets in the illiquid private markets. That is the miracle of market failure and of divergent private, public and social valuations. The SPV is a pure veil from a substantive, economic perspective.
The reason governments like the SPV arrangement is that, in many cases, the governments accounts, both for domestic and international reporting purposes, would record the guarantee fee as current government budget receipts. The contingent liability represented by the guarantee would not be recorded as a liability in the balance sheet. Only if, at some future time, the guarantee would be called, because the SPV defaulted on its bonds, would the government’s liability, no longer contingent but realised, show up in the accounts, as an outlay. With myopic governments, who know they may not be in office if and when the SPV defaults, the future is a much discounted concept.
It would of course be equally inappropriate to count the maximum value of the realised exposure as a liability. That would be the face value of the former private bank assets; unless default with zero recovery value is a certainty, that overstates the fair value of the state’s exposure.
Spaventa’s SPV proposal is, from an economic point of view, if the SPV pays the right (fair) price to the state for the guarantee, equivalent to the outright, direct purchase of the private bank assets by the state, through a swap of the bank assets (at a proper discount to face value) for Treasury bonds. The fair value of the guarantee in the SPV arrangement equals the difference between the face value of the bank assets and the value of the Treasury bonds the private banks would receive if there were an outright purchase of these assets by the state.
Under this direct outright purchase agreement, the state would end up with liabilities equal to the additional Treasury bonds transferred to the private banks and with financial assets equal to the fair value of the former private bank assets. Provided these have been valued properly, marked-to-fair value assets and liabilies would go up by the same amount, with no change in government net worth, just like under Spaventa’s SPV proposal.
Another transparent, but from an economic point of view equivalent alternative to Spaventa’s government-sponsored SPV with a state guarantee for the SPV debt, would be for the state to directly guarantee the private bank assets, with the banks keeping these assets on their balance sheets. The cost to the banks of the guarantee would be the same as the cost of the guarantee paid by the SPV to the government under Spaventa’s arrangement. It would also equal the difference between the face value of the private bank assets acquired by the government and the value of the Treasury bonds the banks end up with in the case of the outright purchase of bank assets by the state.
As stated earlier, giving standard accounting conventions, Spaventa’s preferred implementation of the government guarantee of the private bank assets – doing it in a roundabout way by having the Treasury guarantee the bonds issued by some publicly sponsored (no doubt off-balance-sheet) entity (i.e. by an SPV) – only serves to obscure who is taking on what risk. The state-sponsored entity does not take on any risk. It is the state, which guarantees the bonds issued by the SPV, that assumes the risk, in exchange for the guarantee fee.
I have no problem in principle with a special entity acquiring the bank assets and managing that portfolio as an agent of the state. Managing a portfolio of banking assets is not a skill commonly found in the public sector, so it makes sense to contract it out. But this solution is acceptable only if the contingent liability acquired by the government is fully accounted for on the government’s balance sheet. In practice, getting an SPV to acquire the private bank assets with a sovereign guarantee for the SPV bonds issued to acquire the assets would allow the government to keep both the liabilities and the assets out of the public sector balance sheet. In the short run, only the receipt of the guarantee premium from the SPV would show up in the government accounts. The fact that the guarantee may be called upon if the former bank assets now held by the SPV fail to perform is out of sight and out of mind.
The original ‘Brady bonds’ were also an unnecessarily complicated, extensively window-dressed re-arrangement of a very simple underlying write-off of debt and trade of risk exposure.Private banks’ balance sheet in the US carried lots of non-performing emerging market loans. These loans were swapped for long-term ‘Brady bonds’ with the same remaining maturity. The terms of the swap implied a market value for the non-performing loans that represented a steep discount on the original face value. These Brady bonds (which were the liabilities of the original borrowing governments) were collateralised by US Treasury securities of corresponding maturities purchased by the issuers and held in escrow at the Federal Reserve. I believe the US Treasury securities were purchased by the debtor governments at market value from the US government.
The Brady bonds were completely redundant in this arrangement. The debtor governments could simply have exchanged the (discounted) non-performing loans directly for the US Treasury securities they had purchased. Indeed, since US Treasury securities are nearly perfectly liquid, the debtor governments could simply have bought back their discounted non-performing loans at the agreed discount, using US dollars (or indeed any convertible currency), leaving the decision on how to invest the money (in US Treasury securities or anything else) to the creditor banks. So the Brady bond experiment was just another example of complicating something fundamentally very simple, without changing its economic substance.
In the Brady bond scheme the creditor banks took a hit relative to their original valuation – at par – of the loans they made; the borrowing emerging market governments (mainly Latin American) made a matching gain. There was no fiscal subsidy to anyone, assuming the borrowing governments paid fair market prices for the Treasury debt they put in escrow at the Fed.
In Spaventa’s scheme, as long as the SPV pays the government a fair fee for the guarantee on its bonds, there is no public sector subsidy either, even though the private banks clearly benefit from the transaction (economics is almost never a zero sum game – in a distorted equilibrium, it can be a positive or a negative sum game). There is only a public sector subsidy if the SPV does not pay a fair fee for the guarantee. In that case, the difference between the fair fee and the fee actually paid is a subsidy either to the SPV or to the private banks. The equivalent outcome when the state engages in direct purchases of private bank assets would be achieved if the state paid more than the fair (default risk-adjusted) value for the assets.
Since in the Spaventa SPV or direct outright purchase approaches the private bank assets are bought at a discount relative to their face value, there clearly has been some redistribution between the original borrowers from the banks (whose liabilities correspond to the assets the banks are now trying to get rid of) and the banks. But that distributional issue is distinct from any fiscal transfer from the Treasury to the private banks under the Spaventa or direct outright purchase proposals.
Honesty in government and accountability of government to its masters, the electorate, are far more important than the resolution of the current financial crisis. So even if there were no equally effective alternative to the disguised outright purchase by the state of illiquid or impaired assets proposed by Spaventa, the SPV solution should still be rejected, because it undermines the transparency of the public accounts. The voters have the right to know the exact extent of the exposure to private credit risk that the state is assuming. Hiding that exposure in some state-owned or state-guaranteed off-balance sheet vehicle would undermine democratic accountability.
Fortunately, there is no need to choose between financial stability and democratic accountability. The easiest way to make sure the government achieves the economic substance of what Spaventa proposes without any accounting window dressing is for the government to acquire the illiquid private bank assets outright through a direct purchase. This could be done through an agency of the Treasury or by even the central bank, as long as the accounts of the central bank are consolidated with those of the general government sector, to get a full and fair representation of the assets and liabilities of the sovereign.