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How CDOs, CMOs, LILOs and SILOs All Turned into Alphabet Soup
As we all know, the United States and the world are facing the greatest financial crisis since the Great Depression. Jobs have been lost, credit markets have seized up, and the economy by anyone's standards is in a recession. The general consensus is that due to this crisis an entirely new economic structure may be in place before it is over.
This recession has, of course, affected the leasing industry as well and the large-ticket, tax-oriented market in particular. Volumes in the large-ticket sector have declined dramatically over the last few years. All one needs to do is read the stories in the newspaper or go online to see how the industry has been affected.
One of the big stories over the past few years in the large-ticket leasing business has been the Lease In Lease Out/Sale In Lease Outs (“LILO/SILOs”) and how the Internal Revenue Service (“IRS”) has been winning most of the court cases brought to trial regarding these transactions, how it has offered settlements to the various investors, and how many of the guarantors have fallen below required thresholds in these transactions. Most of these declines in the credit ratings of the guarantors were caused by the larger crisis itself.
While the larger economic crisis may have had a direct causal effect on the LILO/SILO crisis, there are a number of parallels that may be drawn between these separate but intertwined events. This article provides a very condensed version of both the current global crisis and the problems that exist in the LILO/SILO transactions and then draws some unseen parallels shared by each of them. In addition, some conclusions are drawn as to what may be learned from these events. Unfortunately history does have a way of repeating itself, and these lessons may not be learned.
The Global Crisis
Reading the financial journals, magazines, and almost anything else available it is generally conceded that this global crisis was due to, at its roots, a loosening of credit standards, particularly in the housing market in the United States. The lax standards manifested themselves in several ways including high loan to value ratios, belief that the value of the underlying asset would always rise, and lack of credit standards being applied to the borrowers.
Ratings of CDOs, CMOs, etc., into which these debt products were aggregated, of AAA by the rating agencies, did not adequately reflect the true credit worthiness of these instruments. There is much question as to who is to blame including:
1) the mortgage brokers who sold transactions to people who they knew could not afford them;
2) the bankers who purchased these mortgages and sold them to packagers;
3) the investment bankers who packaged them and bundled them into CMOs and CDOs;
4) the institutions that ultimately owned the packages; and finally
5) the rating agencies that did not do their proper due diligence in assigning ratings to these instruments that were clearly way too high.
It is interesting to note that the court of public opinion does not at all seem to blame the people who borrowed money and never had a prayer of paying it back. The crisis is in the process of being solved through the intervention of the federal government and other governments around the world at costs of trillions of dollars to taxpayers.
LILOs/SILOs
We will now look at the parallel universe that exists in the LILO/SILO transactions and then see how this crisis may compare to the mortgage crisis mentioned above. For those unfamiliar with the LILO/SILO structure, a LILO (Lease In/Lease Out) or a SILO ( Sale In/Lease Out) in general worked as follows:
A non taxpayer (municipality, transit agency, foreign organization) would sell or lease its property to a U.S. investor. The investor, now the Lessor or owner for tax purposes, would lease the property back to the tax exempt entity for a period of time during which or at the end of such lease term, the tax exempt entity would have the option to purchase the property back for a fixed price.
At the outset of the lease, the tax exempt entity was required to make certain deposits with credit-worthy institutions (usually AAA rated) to ensure that it would have the money to pay the required rental and purchase price in the event it decided to purchase the asset. If the “credit-worthy entity” were to drop below a certain standard (Aa3 or AA- in most cases) that institution would have to be replaced at the lessee's expense.
Jumping to the present day, many of these institutions that were AAA rated at the inception of the transaction are now no longer meeting the standard. Many of the tax-exempt entities are now facing the reality that the original credit enhancers must be replaced, and there may be a significant cost to that which must be borne by the tax-exempt entity. What sort of resolution are they seeking? Many of these entities are looking for a federal bailout.
The Parallels
Comparing these two seemingly different scenarios above actually leads to the conclusion that the scenarios are not so different after all.
First, the federal government at the outset of each of these products encouraged their existence. The administration in 1999 encouraged the American dream of home ownership and pushed Fannie Mae and others to lower their lending standards to permit more people to own their homes (even though it meant altering credit standards to allow for this sort of lending). Similarly, the Federal Transit Agency (“FTA”) encouraged various transit agencies to enter into the leasing transactions with investors to take advantage of the tax deductions available under such structures (although the Internal Revenue Service had expressed its displeasure with such structures).
Secondly, there was a belief (albeit wrong) amongst the users of the funds in both cases that there was really no risk to these transactions. The mortgage borrowers believed that the prices of homes would keep rising because they always did; and although their borrowings had prohibitively high interest rates after a few years, refinancing would always be possible. Municipalities believed that the AAA rated entities utilized to guarantee their credit would never fall below the AA category. Each of these beliefs was reinforced to these parties by mortgage brokers and investment bankers in order to generate more fee business to them.
The third parallel is that each of these products has affected the respective investors through the principle of “mark to market” accounting. It is well known how the mark to market has affected the value of the mortgages held by banks, etc. lowering their capital, forcing the institution to book losses and the subsequent effect on their capital ratios. What is not as widely perceived but can be gleaned from 10-Ks etc. of various financial institutions is that billions of dollars in write-downs have been taken by large banks and other investors due to the IRS successfully challenging the tax benefits claimed by these investors. (Leveraged lease accounting that was used for these transactions has in effect a “mark to market” feature in it).
Finally the borrowers or users of the funds involved in each of these types of transactions (the mortgagees or the municipalities) are seeking help from the federal government in the form of a bailout of one nature or the other. The mortgagees are getting some help through various congressional actions, but this largess does not seem to be forthcoming in the case of the transit agencies.
Lessons to Be Learned
What are the lessons to be learned from the above?
First, investors and borrowers should certainly do their own credit reviews and due diligence on transactions. The rating agencies cannot be blamed by investors for bad judgment. Investors should do their own stress testing on their downside. While the ratings may be a good proxy and may be used to meet minimum standards to be able to sell down an instrument, the ultimate credit risk lies with the investor. Investors must understand the risks that are being taken. It is clear that the investors who now own the “toxic waste” did not fully understand the product that they were sold. On the other hand, investors in the SILO/LILO transactions did understand the risk they were taking on, lived with it, and when things went against them had not put the entire company at risk and also were not looking for help from the taxpayers.
Secondly, if you are in need of money and someone tells you there are no risks in a transaction, hire competent counsel, read the documents, and determine the risks. There are always risks. AAA companies do get downgraded. Housing prices do go down. Credit does tighten up. These “once every hundred year” risks seem to be occurring a little more frequently than that now. (Remember the Long-Term Capital Management fiasco a few years ago?)
Thirdly, if you do make a mistake and are in an arrangement where losses are to be taken, be sure to walk in a very large crowd. The federal government is doing all it can do to bail out mortgage lenders and borrowers at the expense of the U.S. taxpayer. The municipalities are not hearing the same sympathetic ear. The mortgage mess is big enough to have “nationalization” of the banking industry considered. The LILO/SILO issue is not. Perhaps the old adage about not jumping off the bridge just because everyone else did is no longer true. Because if you did and so did everyone else, you stand a much better chance of being rescued.
Howard K. Weber, a member of this newsletter's Board of Editors, is a Director with Collateral Guaranty LLC (http://www.residvalue.com/), a consultant to the leasing and insurance industries, and has been working in the leasing industry for more than 30 years. He may be reached at 646-824-4946 or [email protected].
As we all know, the United States and the world are facing the greatest financial crisis since the Great Depression. Jobs have been lost, credit markets have seized up, and the economy by anyone's standards is in a recession. The general consensus is that due to this crisis an entirely new economic structure may be in place before it is over.
This recession has, of course, affected the leasing industry as well and the large-ticket, tax-oriented market in particular. Volumes in the large-ticket sector have declined dramatically over the last few years. All one needs to do is read the stories in the newspaper or go online to see how the industry has been affected.
One of the big stories over the past few years in the large-ticket leasing business has been the Lease In Lease Out/Sale In Lease Outs (“LILO/SILOs”) and how the Internal Revenue Service (“IRS”) has been winning most of the court cases brought to trial regarding these transactions, how it has offered settlements to the various investors, and how many of the guarantors have fallen below required thresholds in these transactions. Most of these declines in the credit ratings of the guarantors were caused by the larger crisis itself.
While the larger economic crisis may have had a direct causal effect on the LILO/SILO crisis, there are a number of parallels that may be drawn between these separate but intertwined events. This article provides a very condensed version of both the current global crisis and the problems that exist in the LILO/SILO transactions and then draws some unseen parallels shared by each of them. In addition, some conclusions are drawn as to what may be learned from these events. Unfortunately history does have a way of repeating itself, and these lessons may not be learned.
The Global Crisis
Reading the financial journals, magazines, and almost anything else available it is generally conceded that this global crisis was due to, at its roots, a loosening of credit standards, particularly in the housing market in the United States. The lax standards manifested themselves in several ways including high loan to value ratios, belief that the value of the underlying asset would always rise, and lack of credit standards being applied to the borrowers.
Ratings of CDOs, CMOs, etc., into which these debt products were aggregated, of AAA by the rating agencies, did not adequately reflect the true credit worthiness of these instruments. There is much question as to who is to blame including:
1) the mortgage brokers who sold transactions to people who they knew could not afford them;
2) the bankers who purchased these mortgages and sold them to packagers;
3) the investment bankers who packaged them and bundled them into CMOs and CDOs;
4) the institutions that ultimately owned the packages; and finally
5) the rating agencies that did not do their proper due diligence in assigning ratings to these instruments that were clearly way too high.
It is interesting to note that the court of public opinion does not at all seem to blame the people who borrowed money and never had a prayer of paying it back. The crisis is in the process of being solved through the intervention of the federal government and other governments around the world at costs of trillions of dollars to taxpayers.
LILOs/SILOs
We will now look at the parallel universe that exists in the LILO/SILO transactions and then see how this crisis may compare to the mortgage crisis mentioned above. For those unfamiliar with the LILO/SILO structure, a LILO (Lease In/Lease Out) or a SILO ( Sale In/Lease Out) in general worked as follows:
A non taxpayer (municipality, transit agency, foreign organization) would sell or lease its property to a U.S. investor. The investor, now the Lessor or owner for tax purposes, would lease the property back to the tax exempt entity for a period of time during which or at the end of such lease term, the tax exempt entity would have the option to purchase the property back for a fixed price.
At the outset of the lease, the tax exempt entity was required to make certain deposits with credit-worthy institutions (usually AAA rated) to ensure that it would have the money to pay the required rental and purchase price in the event it decided to purchase the asset. If the “credit-worthy entity” were to drop below a certain standard (Aa3 or AA- in most cases) that institution would have to be replaced at the lessee's expense.
Jumping to the present day, many of these institutions that were AAA rated at the inception of the transaction are now no longer meeting the standard. Many of the tax-exempt entities are now facing the reality that the original credit enhancers must be replaced, and there may be a significant cost to that which must be borne by the tax-exempt entity. What sort of resolution are they seeking? Many of these entities are looking for a federal bailout.
The Parallels
Comparing these two seemingly different scenarios above actually leads to the conclusion that the scenarios are not so different after all.
First, the federal government at the outset of each of these products encouraged their existence. The administration in 1999 encouraged the American dream of home ownership and pushed
Secondly, there was a belief (albeit wrong) amongst the users of the funds in both cases that there was really no risk to these transactions. The mortgage borrowers believed that the prices of homes would keep rising because they always did; and although their borrowings had prohibitively high interest rates after a few years, refinancing would always be possible. Municipalities believed that the AAA rated entities utilized to guarantee their credit would never fall below the AA category. Each of these beliefs was reinforced to these parties by mortgage brokers and investment bankers in order to generate more fee business to them.
The third parallel is that each of these products has affected the respective investors through the principle of “mark to market” accounting. It is well known how the mark to market has affected the value of the mortgages held by banks, etc. lowering their capital, forcing the institution to book losses and the subsequent effect on their capital ratios. What is not as widely perceived but can be gleaned from 10-Ks etc. of various financial institutions is that billions of dollars in write-downs have been taken by large banks and other investors due to the IRS successfully challenging the tax benefits claimed by these investors. (Leveraged lease accounting that was used for these transactions has in effect a “mark to market” feature in it).
Finally the borrowers or users of the funds involved in each of these types of transactions (the mortgagees or the municipalities) are seeking help from the federal government in the form of a bailout of one nature or the other. The mortgagees are getting some help through various congressional actions, but this largess does not seem to be forthcoming in the case of the transit agencies.
Lessons to Be Learned
What are the lessons to be learned from the above?
First, investors and borrowers should certainly do their own credit reviews and due diligence on transactions. The rating agencies cannot be blamed by investors for bad judgment. Investors should do their own stress testing on their downside. While the ratings may be a good proxy and may be used to meet minimum standards to be able to sell down an instrument, the ultimate credit risk lies with the investor. Investors must understand the risks that are being taken. It is clear that the investors who now own the “toxic waste” did not fully understand the product that they were sold. On the other hand, investors in the SILO/LILO transactions did understand the risk they were taking on, lived with it, and when things went against them had not put the entire company at risk and also were not looking for help from the taxpayers.
Secondly, if you are in need of money and someone tells you there are no risks in a transaction, hire competent counsel, read the documents, and determine the risks. There are always risks. AAA companies do get downgraded. Housing prices do go down. Credit does tighten up. These “once every hundred year” risks seem to be occurring a little more frequently than that now. (Remember the Long-Term Capital Management fiasco a few years ago?)
Thirdly, if you do make a mistake and are in an arrangement where losses are to be taken, be sure to walk in a very large crowd. The federal government is doing all it can do to bail out mortgage lenders and borrowers at the expense of the U.S. taxpayer. The municipalities are not hearing the same sympathetic ear. The mortgage mess is big enough to have “nationalization” of the banking industry considered. The LILO/SILO issue is not. Perhaps the old adage about not jumping off the bridge just because everyone else did is no longer true. Because if you did and so did everyone else, you stand a much better chance of being rescued.
Howard K. Weber, a member of this newsletter's Board of Editors, is a Director with Collateral Guaranty LLC (http://www.residvalue.com/), a consultant to the leasing and insurance industries, and has been working in the leasing industry for more than 30 years. He may be reached at 646-824-4946 or [email protected].
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