The Disappearance of Qs: A Knockout Punch to Securitizations?

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 subprime mortgage pools. The Financial Accounting Standards Board (“FASB”) responded by accelerating its ongoing review of the accounting standards for securitization vehicles.

Earlier this year, the FASB proposed revisions to some of these standards, particularly Financial Accounting Standard 140 (“FAS 140″) and FASB Interpretation No. 46 (“FIN 46″). More recently, on Sept. 15, 2008, the FASB issued three separate, but related, exposure drafts for public comment. The first two exposure drafts were proposed amendments to FAS 140 and FIN 46 that would be effective for fiscal years that begin after Nov. 15, 2009. The third exposure draft was of a Staff Position that is intended to improve disclosures by public entities until the pending amendments to FAS 140 and FIN 46 are effective.

While each of these changes is intended to improve financial disclosures and reporting for the benefit of investors, the cumulative effect could be devastating to the securitization market. The most potentially significant is the proposal to revise FAS 140. If implemented in the current form, it would 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 impaired assets, requiring larger reserves and resulting in more losses. The consequences could range from breaching financial covenants in loans and bond indentures to triggering regulatory capital thresholds.

This proposal grew out of a sense among regulators that some originators had made improper use of Qs when pooling subprime loans. Within the accounting profession there was a broader concern that the range of financial assets being securitized and the complexity of the structures had resulted in the Q concept being stretched beyond its original purpose. Paradoxically, however, the recent turmoil in financial markets may cause government officials to reverse their position. With so many financial institutions teetering on the edge of failure, regulators are concerned that compelling troubled institutions to bring troubled assets onto their balance sheets could trip regulatory capital requirements for some institutions. It is too soon to predict what effect the confluence of these competing concerns may have on the review process. However, it seems that some reform is likely.

At first look, the elimination of Qs might seem to be a technical accounting issue. However, if this change is implemented, it would have a significant impact on future securitizations as well as on originators of existing securitizations that had relied on the Q structure. The consequences may be far reaching, particularly in the face of so much market turmoil. To understand the scope of the issue, 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 provided 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 value from a variety of cash-producing assets. These are generally loans, but offerings secured by equipment leases and credit card receivables also became common. With this diversity of offerings, securitizations grew from non-existent in 1970 to a $7 trillion annual market in 2007.

Initially developed to access capital markets and convert financial assets into cash, securitizations also lower borrowing costs and disperse credit risk. As a result, they have provided enormous volumes of low-cost capital to lenders, which 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 increasingly complex structures. Securitizations did 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 the accounting profession has been debating 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. Classifying 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 can 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, the originator avoids the need to make reserves for non-performing assets or adjustments to reflect a lack of liquidity. That provides a unique advantage to regulated financial institutions: Removing loans from their balance sheet can 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

Revisions to FAS 140 have been under consideration, more or less, since 2003, but prior exposure drafts elicited enough negative comment to halt the process. On April 2, 2008, however, the FASB proposed to revise FAS 140 by eliminating Qs, which are essentially a standard for determining whether the assets and liabilities of a securitization must be recognized on the balance sheet of its originator. Initially, the FASB, under pressure from regulators, had proposed to make the new rules effective by the end of 2008. But, when the FASB finally issued the exposure draft of the new standards on Sept. 15, 2008, it proposed to implement the changes for fiscal years that commence after Nov. 15, 2009. So, for calendar year reporting entities, these changes would not apply until 2010. However, to compensate for the delay in implementing the new standards, the FASB also proposed to improve the disclosures by public entities until the proposed amendments became effective.

Originally, FAS 140 had envisioned the Q as holding financial assets in a passive way that caused it to be equated to a lockbox. But the deterioration of the credit markets 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 and Exchange Commission 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 seemed to have spurred the process forward. 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.

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

Although the onset of deteriorating economic conditions had accelerated the current review process, the continued economic downturn may cause the FASB to shift gears. It has already decided that any changes it makes will be postponed into next year. Meanwhile, the potential for further damage to already deteriorating balance sheets may cause government and industry regulators to reconsider the wisdom of these proposals in their entirety. Nevertheless, it seems possible that changes of some type are coming and that modifications to FAS 140 will have an impact on structures that currently qualify for sale accounting treatment under FAS 140. Forcing originators to add illiquid or underperforming financial assets to their troubled balance sheets will send more shock waves through markets that are already reeling.

Once touted for providing liquidity and low interest rates, securitizations have more recently been blamed for the collapse of real estate values, the evaporation of credit, and the implosion of major financial institutions such as Lehman Brothers, AIG, Merrill Lynch, and Washington Mutual. The fallout from some of these 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 in its Commercial Restructuring & Bankruptcy Group and Derivatives & Structured Products Group.

Securitization markets are reeling from a devastating series of blows. It began last year with the subprime crisis. This year ' so far ' has brought a credit crisis, the collapse of the stock market, and the disappearance of major financial institutions. Meanwhile, politicians and regulators, looking for explanations and scapegoats, are considering new regulatory schemes to “rein in” a securitization system that former Federal Reserve Chairman Alan Greenspan recently told Congress was at the heart of the breakdown of credit markets. (See, remarks of Alan Greenspan before the House Committee on Oversight and Government Reform on Oct. 23, 2008. In his testimony, Dr. Greenspan felt constrained to make his own proposal for securitization reform. “As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty surveillance.”)

So, it is no surprise that the securitization markets resemble a battered boxer who is struggling to stay on his feet while hoping to avoid the next, possibly final, punch. The accounting industry may be poised to deliver that punch. Proposed changes to accounting rules for securitization vehicles will further challenge this already fragile market, threatening its role as a significant source of liquidity.

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 subprime mortgage pools. The Financial Accounting Standards Board (“FASB”) responded by accelerating its ongoing review of the accounting standards for securitization vehicles.

Earlier this year, the FASB proposed revisions to some of these standards, particularly Financial Accounting Standard 140 (“FAS 140″) and FASB Interpretation No. 46 (“FIN 46″). More recently, on Sept. 15, 2008, the FASB issued three separate, but related, exposure drafts for public comment. The first two exposure drafts were proposed amendments to FAS 140 and FIN 46 that would be effective for fiscal years that begin after Nov. 15, 2009. The third exposure draft was of a Staff Position that is intended to improve disclosures by public entities until the pending amendments to FAS 140 and FIN 46 are effective.

While each of these changes is intended to improve financial disclosures and reporting for the benefit of investors, the cumulative effect could be devastating to the securitization market. The most potentially significant is the proposal to revise FAS 140. If implemented in the current form, it would 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 impaired assets, requiring larger reserves and resulting in more losses. The consequences could range from breaching financial covenants in loans and bond indentures to triggering regulatory capital thresholds.

This proposal grew out of a sense among regulators that some originators had made improper use of Qs when pooling subprime loans. Within the accounting profession there was a broader concern that the range of financial assets being securitized and the complexity of the structures had resulted in the Q concept being stretched beyond its original purpose. Paradoxically, however, the recent turmoil in financial markets may cause government officials to reverse their position. With so many financial institutions teetering on the edge of failure, regulators are concerned that compelling troubled institutions to bring troubled assets onto their balance sheets could trip regulatory capital requirements for some institutions. It is too soon to predict what effect the confluence of these competing concerns may have on the review process. However, it seems that some reform is likely.

At first look, the elimination of Qs might seem to be a technical accounting issue. However, if this change is implemented, it would have a significant impact on future securitizations as well as on originators of existing securitizations that had relied on the Q structure. The consequences may be far reaching, particularly in the face of so much market turmoil. To understand the scope of the issue, 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 provided 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 value from a variety of cash-producing assets. These are generally loans, but offerings secured by equipment leases and credit card receivables also became common. With this diversity of offerings, securitizations grew from non-existent in 1970 to a $7 trillion annual market in 2007.

Initially developed to access capital markets and convert financial assets into cash, securitizations also lower borrowing costs and disperse credit risk. As a result, they have provided enormous volumes of low-cost capital to lenders, which 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 increasingly complex structures. Securitizations did 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 the accounting profession has been debating 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. Classifying 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 can 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, the originator avoids the need to make reserves for non-performing assets or adjustments to reflect a lack of liquidity. That provides a unique advantage to regulated financial institutions: Removing loans from their balance sheet can 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

Revisions to FAS 140 have been under consideration, more or less, since 2003, but prior exposure drafts elicited enough negative comment to halt the process. On April 2, 2008, however, the FASB proposed to revise FAS 140 by eliminating Qs, which are essentially a standard for determining whether the assets and liabilities of a securitization must be recognized on the balance sheet of its originator. Initially, the FASB, under pressure from regulators, had proposed to make the new rules effective by the end of 2008. But, when the FASB finally issued the exposure draft of the new standards on Sept. 15, 2008, it proposed to implement the changes for fiscal years that commence after Nov. 15, 2009. So, for calendar year reporting entities, these changes would not apply until 2010. However, to compensate for the delay in implementing the new standards, the FASB also proposed to improve the disclosures by public entities until the proposed amendments became effective.

Originally, FAS 140 had envisioned the Q as holding financial assets in a passive way that caused it to be equated to a lockbox. But the deterioration of the credit markets 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 and Exchange Commission 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 seemed to have spurred the process forward. 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.

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

Although the onset of deteriorating economic conditions had accelerated the current review process, the continued economic downturn may cause the FASB to shift gears. It has already decided that any changes it makes will be postponed into next year. Meanwhile, the potential for further damage to already deteriorating balance sheets may cause government and industry regulators to reconsider the wisdom of these proposals in their entirety. Nevertheless, it seems possible that changes of some type are coming and that modifications to FAS 140 will have an impact on structures that currently qualify for sale accounting treatment under FAS 140. Forcing originators to add illiquid or underperforming financial assets to their troubled balance sheets will send more shock waves through markets that are already reeling.

Once touted for providing liquidity and low interest rates, securitizations have more recently been blamed for the collapse of real estate values, the evaporation of credit, and the implosion of major financial institutions such as Lehman Brothers, AIG, Merrill Lynch, and Washington Mutual. The fallout from some of these 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 in its Commercial Restructuring & Bankruptcy Group and Derivatives & Structured Products Group.