More Bad News for Structured Finance?

If implemented, these changes could require financial companies to consolidate the balance sheets of securitization entities that had previously been classified as qualified special purpose entities (“QSPEs,” but more commonly referred to as “Qs”). In the current economic environment, that consolidation would swell their balance sheets with more losses. The consequences could range from breaching financial covenants in loans and bond indentures to triggering regulatory capital thresholds.

There has been a sense among regulators that some originators made improper use of Qs when they pooled subprime loans to issue securities. But, within the accounting profession there has been a longer-standing and broader concern that the concept of a Q as envisioned by the current accounting standards is unworkable.

Revisions to FAS 140 have been under consideration, more or less, since 2005 when a draft revision elicited enough negative comment to halt the process. But, on April 2, 2008, the FASB agreed, conceptually, to revise FAS 140 to eliminate Qs, which is essentially a bright-line, standard for determining whether the assets and liabilities of a securitization must be recognized on the balance sheet of its originator. Since making that decision, the FASB staff has focused on the details necessary to implement this new policy. The release of an exposure draft of the new standards is now planned for the third quarter, which will be followed by a 60-day comment period.

The elimination of Qs may seem to be a technical accounting issue. However, the consequences may be far reaching. To understand the scope of the problem, a little history is necessary.

Background

Securitization is the creation and issuance of debt securities whose payments of principal and interest are made from the cash flows generated by a pool of income-generating assets that has been pledged to secure the payments. The technique was developed during the 1970s to increase liquidity in the secondary market for home mortgages. The government sponsored entities Fannie Mae and Freddie Mac began by issuing guaranteed mortgage pass-through securities to enhance the secondary market in home mortgages. Eventually, when efficient securitization structures were developed, it became apparent that the process could be used for other types of financial assets.

By 1985, securitizations were used for pools of automobile loans. These loans have several of the characteristics that had made mortgages good candidates for structured financings. First, there were a lot of them; after home mortgages, automobile loans were the most common form of secured loans. Second, their maturities ' considerably shorter than those of mortgages ' made the timing of cash flows more predictable. Finally, statistical histories of performance provide investors with enough data to judge value, making them attractive in the market.

Over the ensuing years, businesses of all types have used securitizations to realize the value of a variety of cash-producing assets. These are generally loans, but can also be trade receivables, equipment leases or credit card receivables. With this diversity of offerings, securitizations grew from non-existent in 1970 to a $7 trillion annual market in 2007.

Securitizations have many advantages. Initially developed to access capital markets and convert financial assets into cash, they also lower borrowing costs and disperse credit risk. They have provided increasing volumes of low-cost capital to lenders, which had caused interest rates to fall and make credit more available to consumers and businesses.

As the securitization market evolved into a major economic force, the accounting profession tried to develop standards that would deal with the increasingly complex structures employed for the transfer of pools of financial assets. Securitizations do not fit neatly into the traditional accounting framework. By design, the securitization is a self-liquidating transaction, not an operating business. It is actually a process of stratifying assets by risk, with measurement and reporting procedures that are dictated by the requirements of the credit rating process. By contrast, traditional accounting methodology is designed to define and quantify the impact of commercial activities and decisions on the financial position of an on-going entity. How and where securitizations fit in that process is a question that accounting has been trying to answer for the last two decades.

Derecognition

The major accounting driver for securitizations is euphemistically known as “derecognition,” a concept familiar to anyone who followed the collapse of Enron. Derecognition is the removal of a financial asset from the balance sheet through sale or payment. With derecognition, a securitization entity recognizes the financial and servicing assets it controls and the liabilities it incurs, while the sponsor can “derecognize” financial assets when it surrenders control and “derecognize” liabilities when they are extinguished. While the sale of the asset pool triggers derecognition, that sale is also critical to isolating and protecting the value of the financial assets.

The sale of financial assets by the originator to a special purpose entity (“SPE”), such as a trust or limited liability company, is a crucial component of securitization since it isolates the assets in an entity that has no business except to collect revenues from the asset pool and repay principal and interest to its investors. The proceeds of the securities issued by the SPE are remitted to the originator as the sale price for the assets. Qualifying this transfer as a “true sale” is critical. A true sale protects the cash stream and ensures that it is available to make payments to the investors, who can look only to the securitization for payments due on their notes and not to the revenues of the originator. Without a true sale, the assets or the cash flows they generate might be vulnerable to claims of creditors of the originator.

Selling the assets also benefits the originator. The sale generates cash that may be treated as income, while freeing up capital to originate new business. Moreover, when the assets are sold to the SPE, they are removed from the originator's balance sheet (that is, derecognized). Derecognizing the assets and liabilities while simultaneously increasing income has a positive effect on the originator's financial metrics, such as return-on-assets. Also, in a declining market such as the current environment, the originator avoids the need to make reserves for non-performing assets or adjustments to reflect lack of liquidity. That provides a unique advantage to banks: removing loans from their balance sheet may help lower regulatory capital requirements.

The Accounting Issues

But the sale presents several accounting issues. When should transferred assets be considered sold and the resulting gain or loss recorded? Should the assets be treated as collateral for borrowings, or should the transfer be accounted for at all? Should the assets and liabilities be consolidated? If so, by whom? The FASB attempted to address these issues in 1996 when it issued Financial Accounting Standard 125 (“FAS 125″), which provided standards for determining whether a transfer of financial assets should be treated as a sale or as a secured borrowing.

The focus of FAS 125 was on control following the transfer of financial assets. The SPE would recognize the financial and servicing assets it controlled, while the sponsor would derecognize financial assets when it surrendered control. FAS 125 provided criteria for determining when the sponsor had surrendered control. Among those conditions were requirements that: 1) the transferred assets were “beyond the reach” of the sponsor and its creditors, even in bankruptcy and 2) that the sponsor did not “maintain effective control” over the assets through an agreement to repurchase or redeem them before their maturity. These requirements for a sale to an off'balance-sheet entity evolved into standard elements of securitizations.

FAS 140, issued in September 2000, elaborated on the requirements of FAS 125. FAS 140 provided that if the securitization vehicle met certain conditions, it could be classified as a Q and the transfer would be accounted for as a sale. As defined in FAS 140, the Q is a conduit or a custodian that passively holds financial assets for the benefit of beneficial interest holders. FAS 140 lists several conditions that allow a SPE to be classified as a Q. These conditions restrict the types of assets that a Q may hold and the types of activities in which it may engage.

A conforming sale to a Q permits the sponsor to remove the assets from its balance sheet and immediately recognize the cash proceeds of the sale as income. Such bright line rules generally encourage the structuring of transactions to accomplish a particular accounting objective. And that is precisely what happened as these accounting standards for off'balance-sheet entities have been applied to structure a variety of sophisticated financing techniques including synthetic leases, take-or-pay contracts and securitizations.

The Proposed Changes

FAS 140 envisioned the Q as holding financial assets in a passive way that has caused it to be equated to a lockbox. But the deterioration of the credit market revealed the flaws of this model. For example, would the modification of currently performing subprime mortgages that are confronting the possibility of default violate the passive nature of a Q?

In January 2008, the Securities & Exchange Commission (SEC) asked the FASB to immediately address such issues and implement any needed amendments to FAS 140 to make them applicable to fiscal years beginning after Dec. 31, 2008. Although the review of FAS 140 had been an ongoing project at the FASB for several years, this request seems to have accelerated the process.

On April 2, 2008, the FASB voted to eliminate the Q concept from FAS 140 while approving amendments to the FAS 140 derecognition criteria. As revised, the derecognition criteria would require that isolation of financial assets from the transferor and its affiliates be determined by analyzing all arrangements that are made in connection with a transfer. The upcoming exposure draft of the new standards, when it is issued, will provide the necessary details.

If the FASB's decision to eliminate Qs is incorporated into a final standard, sponsors and investors in securitization vehicles will have to review all of their SPEs to determine if the assets and liabilities of these entities must be brought onto the balance sheet.

Conclusion

It is not certain that the current process will be concluded in time for any changes to affect fiscal years commencing after Dec. 31, 2008. However, it seems likely that changes of some type are coming. Whatever the final outcome, it is likely that modifications to FAS 140 will have an effect on structures that currently qualify for sale accounting treatment under FAS 140.

Once touted for providing liquidity and low interest rates, securitizations have more recently been blamed for the implosion of the residential mortgage industry, the resulting collapse of residential real estate values and the evaporation of capital. The fallout from accounting changes could increase their resume of negative consequences.

Michael J. Venditto is partner in the New York office of Reed Smith, where he practices with its Commercial Restructuring & Bankruptcy Group and Derivatives & Structured Products Group.

For the past several months, fears about the future of Fannie Mae and Freddie Mac have been a dark cloud over the economy. These government-sponsored enterprises are securitization machines, helping sustain a secondary market for the huge volume of residential mortgages that are originated each year. If either of them ceased to operate, the real estate and financial markets would be in chaos. While politicians scramble to preserve Fannie Mae and Freddie Mac, more trouble for financial markets looms on the horizon. Proposed changes to accounting rules for securitization vehicles could decrease the significant role of structured finance in providing the liquidity that sustained recent economic expansion.

What Is Happening?

In the two years since the domestic housing market began its contraction, the financial sector has been roiled by financial institutions reporting losses tied to off-balance-sheet investments, particularly securitizations comprised of sub-prime mortgage pools. With reported losses amounting to hundreds of billions of dollars, government regulators and more than a few politicians have called for changes. This has pushed the Financial Accounting Standards Board (“FASB”) to accelerate its ongoing review of the accounting standards for securitization vehicles. Recently, the FASB voted to revise some of these standards, particularly Financial Accounting Standard 140 (“FAS 140″). The proposed changes, which the FASB is trying to implement for fiscal years commencing after Dec. 31, 2008, would have the unfortunate side-effect of escalating pressure on originators and investors that have already reported massive losses.

If implemented, these changes could require financial companies to consolidate the balance sheets of securitization entities that had previously been classified as qualified special purpose entities (“QSPEs,” but more commonly referred to as “Qs”). In the current economic environment, that consolidation would swell their balance sheets with more losses. The consequences could range from breaching financial covenants in loans and bond indentures to triggering regulatory capital thresholds.

There has been a sense among regulators that some originators made improper use of Qs when they pooled subprime loans to issue securities. But, within the accounting profession there has been a longer-standing and broader concern that the concept of a Q as envisioned by the current accounting standards is unworkable.

Revisions to FAS 140 have been under consideration, more or less, since 2005 when a draft revision elicited enough negative comment to halt the process. But, on April 2, 2008, the FASB agreed, conceptually, to revise FAS 140 to eliminate Qs, which is essentially a bright-line, standard for determining whether the assets and liabilities of a securitization must be recognized on the balance sheet of its originator. Since making that decision, the FASB staff has focused on the details necessary to implement this new policy. The release of an exposure draft of the new standards is now planned for the third quarter, which will be followed by a 60-day comment period.

The elimination of Qs may seem to be a technical accounting issue. However, the consequences may be far reaching. To understand the scope of the problem, a little history is necessary.

Background

Securitization is the creation and issuance of debt securities whose payments of principal and interest are made from the cash flows generated by a pool of income-generating assets that has been pledged to secure the payments. The technique was developed during the 1970s to increase liquidity in the secondary market for home mortgages. The government sponsored entities Fannie Mae and Freddie Mac began by issuing guaranteed mortgage pass-through securities to enhance the secondary market in home mortgages. Eventually, when efficient securitization structures were developed, it became apparent that the process could be used for other types of financial assets.

By 1985, securitizations were used for pools of automobile loans. These loans have several of the characteristics that had made mortgages good candidates for structured financings. First, there were a lot of them; after home mortgages, automobile loans were the most common form of secured loans. Second, their maturities ' considerably shorter than those of mortgages ' made the timing of cash flows more predictable. Finally, statistical histories of performance provide investors with enough data to judge value, making them attractive in the market.

Over the ensuing years, businesses of all types have used securitizations to realize the value of a variety of cash-producing assets. These are generally loans, but can also be trade receivables, equipment leases or credit card receivables. With this diversity of offerings, securitizations grew from non-existent in 1970 to a $7 trillion annual market in 2007.

Securitizations have many advantages. Initially developed to access capital markets and convert financial assets into cash, they also lower borrowing costs and disperse credit risk. They have provided increasing volumes of low-cost capital to lenders, which had caused interest rates to fall and make credit more available to consumers and businesses.

As the securitization market evolved into a major economic force, the accounting profession tried to develop standards that would deal with the increasingly complex structures employed for the transfer of pools of financial assets. Securitizations do not fit neatly into the traditional accounting framework. By design, the securitization is a self-liquidating transaction, not an operating business. It is actually a process of stratifying assets by risk, with measurement and reporting procedures that are dictated by the requirements of the credit rating process. By contrast, traditional accounting methodology is designed to define and quantify the impact of commercial activities and decisions on the financial position of an on-going entity. How and where securitizations fit in that process is a question that accounting has been trying to answer for the last two decades.

Derecognition

The major accounting driver for securitizations is euphemistically known as “derecognition,” a concept familiar to anyone who followed the collapse of Enron. Derecognition is the removal of a financial asset from the balance sheet through sale or payment. With derecognition, a securitization entity recognizes the financial and servicing assets it controls and the liabilities it incurs, while the sponsor can “derecognize” financial assets when it surrenders control and “derecognize” liabilities when they are extinguished. While the sale of the asset pool triggers derecognition, that sale is also critical to isolating and protecting the value of the financial assets.

The sale of financial assets by the originator to a special purpose entity (“SPE”), such as a trust or limited liability company, is a crucial component of securitization since it isolates the assets in an entity that has no business except to collect revenues from the asset pool and repay principal and interest to its investors. The proceeds of the securities issued by the SPE are remitted to the originator as the sale price for the assets. Qualifying this transfer as a “true sale” is critical. A true sale protects the cash stream and ensures that it is available to make payments to the investors, who can look only to the securitization for payments due on their notes and not to the revenues of the originator. Without a true sale, the assets or the cash flows they generate might be vulnerable to claims of creditors of the originator.

Selling the assets also benefits the originator. The sale generates cash that may be treated as income, while freeing up capital to originate new business. Moreover, when the assets are sold to the SPE, they are removed from the originator's balance sheet (that is, derecognized). Derecognizing the assets and liabilities while simultaneously increasing income has a positive effect on the originator's financial metrics, such as return-on-assets. Also, in a declining market such as the current environment, the originator avoids the need to make reserves for non-performing assets or adjustments to reflect lack of liquidity. That provides a unique advantage to banks: removing loans from their balance sheet may help lower regulatory capital requirements.

The Accounting Issues

But the sale presents several accounting issues. When should transferred assets be considered sold and the resulting gain or loss recorded? Should the assets be treated as collateral for borrowings, or should the transfer be accounted for at all? Should the assets and liabilities be consolidated? If so, by whom? The FASB attempted to address these issues in 1996 when it issued Financial Accounting Standard 125 (“FAS 125″), which provided standards for determining whether a transfer of financial assets should be treated as a sale or as a secured borrowing.

The focus of FAS 125 was on control following the transfer of financial assets. The SPE would recognize the financial and servicing assets it controlled, while the sponsor would derecognize financial assets when it surrendered control. FAS 125 provided criteria for determining when the sponsor had surrendered control. Among those conditions were requirements that: 1) the transferred assets were “beyond the reach” of the sponsor and its creditors, even in bankruptcy and 2) that the sponsor did not “maintain effective control” over the assets through an agreement to repurchase or redeem them before their maturity. These requirements for a sale to an off'balance-sheet entity evolved into standard elements of securitizations.

FAS 140, issued in September 2000, elaborated on the requirements of FAS 125. FAS 140 provided that if the securitization vehicle met certain conditions, it could be classified as a Q and the transfer would be accounted for as a sale. As defined in FAS 140, the Q is a conduit or a custodian that passively holds financial assets for the benefit of beneficial interest holders. FAS 140 lists several conditions that allow a SPE to be classified as a Q. These conditions restrict the types of assets that a Q may hold and the types of activities in which it may engage.

A conforming sale to a Q permits the sponsor to remove the assets from its balance sheet and immediately recognize the cash proceeds of the sale as income. Such bright line rules generally encourage the structuring of transactions to accomplish a particular accounting objective. And that is precisely what happened as these accounting standards for off'balance-sheet entities have been applied to structure a variety of sophisticated financing techniques including synthetic leases, take-or-pay contracts and securitizations.

The Proposed Changes

FAS 140 envisioned the Q as holding financial assets in a passive way that has caused it to be equated to a lockbox. But the deterioration of the credit market revealed the flaws of this model. For example, would the modification of currently performing subprime mortgages that are confronting the possibility of default violate the passive nature of a Q?

In January 2008, the Securities & Exchange Commission (SEC) asked the FASB to immediately address such issues and implement any needed amendments to FAS 140 to make them applicable to fiscal years beginning after Dec. 31, 2008. Although the review of FAS 140 had been an ongoing project at the FASB for several years, this request seems to have accelerated the process.

On April 2, 2008, the FASB voted to eliminate the Q concept from FAS 140 while approving amendments to the FAS 140 derecognition criteria. As revised, the derecognition criteria would require that isolation of financial assets from the transferor and its affiliates be determined by analyzing all arrangements that are made in connection with a transfer. The upcoming exposure draft of the new standards, when it is issued, will provide the necessary details.

If the FASB's decision to eliminate Qs is incorporated into a final standard, sponsors and investors in securitization vehicles will have to review all of their SPEs to determine if the assets and liabilities of these entities must be brought onto the balance sheet.

Conclusion

It is not certain that the current process will be concluded in time for any changes to affect fiscal years commencing after Dec. 31, 2008. However, it seems likely that changes of some type are coming. Whatever the final outcome, it is likely that modifications to FAS 140 will have an effect on structures that currently qualify for sale accounting treatment under FAS 140.

Once touted for providing liquidity and low interest rates, securitizations have more recently been blamed for the implosion of the residential mortgage industry, the resulting collapse of residential real estate values and the evaporation of capital. The fallout from accounting changes could increase their resume of negative consequences.

Michael J. Venditto is partner in the New York office of Reed Smith, where he practices with its Commercial Restructuring & Bankruptcy Group and Derivatives & Structured Products Group.