Securitization Accounting reforms since the financial crisis of 2008
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1 White Paper Securitization Accounting reforms since the financial crisis of 2008 Securitization, the practice of pooling various types of contractual debts and selling the said consolidated debt as bonds to various investors, is known to be one of the most innovative and popular financial tools available. Securitization came under the scanner during the financial crisis of It is believed that weakness in the norms for accounting and financial reporting of securitization contributed to an unchecked surge in securitization activities and its misuse. This, along with other factors like lack of quality control and due diligence, poor loan quality, weak securitization structures, and re-securitizations (Collateralized Debt Obligation Squared) caused the 2008 financial crisis. In this paper, we take a look at the global securitization volumes prior to and post the crisis as well as explore the impact of reforms across geographies. The paper discusses the reforms that have taken place in the United States Generally Accepted Accounting Principles (US GAAP) in the wake of the 2008 crisis, and compares the latest guidelines on accounting and reporting of securitization activities laid down by the International Financial Reporting Standards (IFRS) and the US GAAP.
2 About the Authors Ashwini Kamat Ashwini Kamat is a qualified Chartered Accountant, and a Senior Consultant with TCS Banking Industry Practice, leading the Finance and Reporting sub-practice. She has over 23 years of industry experience, and in her 13 year career with Tata Consultancy Services (TCS), has worked in various roles. She has managed several large engagements, including global implementations of Oracle Financials. In her current role, she is responsible for defining the charter and setting up the Center of Excellence (CoE) for IFRS and XBRL, with the aim to nurture and grow IFRS and XBRL competency within TCS. Along with her team, she mentors and closely works with delivery as well as product teams, and has contributed immensely to the conceptualization and design solutions of the TCS BaNCS suite of products for IFRS compliance. She holds several certifications including CQA, PMP, Six Sigma Black Belt, and IFRS. Akash Agrawal Akash Agrawal is a functional consultant in the Finance and Reporting sub-practice with TCS' Banking Industry practice. He has experience in Financial Reporting,Accounting and Auditing, Taxation, Finance and Banking domain. His current responsibilities include functional specifications for the requirements of IFRS, Basel and FATCA, Risk and Finance Integration. He holds a Chartered Accountant degree from Institute of Chartered Accountants of India securing 32nd All India Rank, a Company Secretary degree from the Institute of Company Secretaries of India, a Master of Commerce degree from the Gujarat University, International Financial Reporting Standards certification from the Institute of Chartered Accountants of India. 2
3 Table of Contents 1. Introduction 4 2. What is securitization? 4 3. Why securitization 4 4. Securitization Growth 5 5. Accounting and Financial Reporting Reforms under US GAAP 6 6. US GAAP and International Financial Reporting Standards (IFRS) provisions affecting securitization 8 7. Conclusion 11 3
4 Introduction Securitization is one of the most innovative financing tools in the market. It has evolved rapidly since its introduction, and reached its peak in terms of both, volume as well as value, during the last decade. Some experts believe that indiscriminate use of securitization by the banking sector to window-dress balance sheets, coupled with the dubious role played by certain credit rating agencies, resulted in the growth of securitization beyond sustainable levels in This is regarded as one of the factors that caused the financial crisis of 2008 and the number of reforms and regulations that have since been introduced confirm this view. In this paper, we take a look at how these reforms have evolved across major economies i.e. in the US and the European Union (EU), since the financial crisis of We also examine if the stringent constraints that have been introduced are creating impediments to the growth of securitization. What is securitization? In the absence of a standard definition, securitization is widely understood to be the practice of pooling, homogenizing and packaging assets to create a standard investment instrument such as the pass- 1 through security. The key features of a securitization transaction are as follows: n n n Sale of primary right to payments against a financial asset (typically loans/ mortgages and other receivables) by an entity Purchase of this right by a Special Purpose Entity (SPE) Issuance of asset/ mortgage backed securities by the SPE Why securitization Financial institutions resort to securitization transactions to realize the following major benefits: Liquidity Securitization enables banks to make assets that are locked up on balance sheets and cannot be sold in the financial markets liquid. This enhances liquidity and helps banks grow rapidly. Risk transfer With securitization, banks can transfer risks associated with assets/ mortgages to the SPE and its investors. Banks can eliminate low quality mortgages from their balance sheets (if they ensure that representations and warranties, used to allocate the risk of mortgage loans between the banks and investors, are not violated). Capital arbitrage Securitization also provides opportunities for capital arbitrage. By converting loan portfolios into suitable tranches and selectively securitizing them, banks can lower regulatory capital requirements. 1. Defining Securitization by Jonathan C. Lipson 4
5 Positive impact on credit Low securitization levels result in funding pressures and a reduction of credit besides a continuing need 2 for central banks and governments to intervene to lift up the banking sector. Thus the healthy growth of securitization is quite important for the stable growth of the banking sector. Securitization Growth With this background, let us look at the securitization statistics for the periods before and after the financial crisis. Figure 1 shows data, focused on North America and Europe. USD Billions Global Securitization Europe Rest of World United States (Q1) 3 Figure 1 Securitization classification by value across the World As can be seen from the data in Figure 1, since the year 2000, the volume of securitization transactions across the globe showed an increasing trend followed by a major fall in Securitization activities have not picked up since the financial crisis of Also, it can be observed that securitization activities in Europe have historically been quite low as compared to the US. As the US is the largest contributor to securitization activities globally, let us specifically examine securitization trends in the US. USD Billions US Securitization (Q1) Others MBS 4 Figure 2 Securitization classification by value in the US As can be seen from Figure 2, in the US, Mortgage Backed Securitization (MBS) constitutes almost 80% of the total securitization volumes. Asset Backed Securitizations (ABS) and others such as collateralized ABS 2. IMF Global Financial Stability Report (GSFR) Oct Global Securitization update by SIFMA 4. Global Securitization update by SIFMA 5
6 USD Billions US-Mortgage Backed Securitization Agency Vs Non-Agency Total Non-Agency Total Agency 5 Figure 3 US MBS - Agency Vs. Non -Agency mortgage obligations (CMO) and residential mortgage-backed securities (RMBS) plunged after 2007 and have not recovered since. MBS transactions in the US mainly consist of agency securitizations through agencies such as Fannie Mae and Freddie Mac. Non-agency securitization (Private Label Securitization) transactions showed an increasing trend prior to Since 2008, there have been almost no non-agency (Private Label) securitization transactions. Various market forces including low investor confidence are responsible for the decline of securitization markets in general and private label securitizations in particular. We will examine the influence, if any, of the changes in accounting/ regulatory requirements in dampening the securitization market, by comparing the regulatory/ accounting norms prior to and post Certain weaknesses that existed in the accounting and reporting requirements under the US GAAP prior to 2008 have since been addressed. Accounting and Financial Reporting Reforms under US GAAP In response to the excessive securitization activities, the US accounting regulator, Financial Accounting Standards Board (FASB), initiated corrective measures by issuing Statements 166 and 167 in June (These statements were subsequently codified by FASB.) The new guidelines that are applicable to financial periods that began after Nov 2009 are presented below: Sr. New provisions under US GAAP (Introduced via Statements 166 and 167 in June 2009 Impact on Securitization/ Accounting A. Removal of the concept of a Qualifying Special Purpose Entity (QSPE) and elimination of its references. The flexibility to designate certain transfers of financial assets to QSPEs and not consolidate QSPEs is no longer available. Due to this change, non-qualifying transfers continue on the balance sheets of the transferors, discouraging the use of securitization to spruce up financial statements. 5. Global Securitization update by SIFMA 6
7 Sr. New provisions under US GAAP (Introduced via Statements 166 and 167 in June 2009 Impact on Securitization/ Accounting B. Stringent derecognition criteria for transferred financial assets. These are : 1. Isolation - - The definition of isolation was modified to ensure that the transferred financial assets are beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any of its consolidated entities, in case of such eventualities 2. Right to pledge / exchange - Unless the transferee has the right to pledge/ exchange the financial assets, the transfer would not qualify as a sale. 3. Effective control - If the transferor of a financial asset continues to have effective control over the transferred assets, such transfer will not qualify as a sale C. Mandatory Fair Valuation of the retained beneficial interest as a new asset. D. Guaranteed Mortgage Securitizations needed to meet the derecognition criteria of Statement 166 to qualify as sale. With such stringent criteria for derecognition in place, most of the transferred assets, especially under Private Label securitizations, continue on the balance sheets of the transferors and will also be included for capital adequacy calculations. This provision targets the tendency to use securitization to eliminate low quality financial assets to spruce up balance sheets and grow rapidly (without adequate capital for sustainable and stable growth). Previous guidelines allowed valuation by other methods, if fair valuation was not feasible. Thus, assets which were previously valued at amortized cost have to be recognized at fair value as per the new provisions. Due to this condition, the resulting gains/ losses on transfers of financial assets will significantly differ as compared to those under previous guidelines. This new requirement specifically targets the tendency to selectively sell/ retain some tranches of low quality assets to achieve regulatory capital arbitrage. Such securitizations will continue to be on the transferor s balance sheet unless they meet the derecognition criteria. E. Additional disclosures have been mandated. Additional disclosures will help users of financial statements to understand fully the impact of transfers on the financial position, profitability and cash flows of the transferor. 7
8 Sr. New provisions under US GAAP (Introduced via Statements 166 and 167 in June 2009 Impact on Securitization/ Accounting F. Statement 167 issued by FASB in June 2009, changed the consolidation and disclosure requirements for Variable Interest Entities (VIE) With these amendments, it becomes necessary for reporting entities to re-assess if the entity in which they held variable interest was indeed a VIE. Certain entities that had been excluded from consolidation, mainly on account of the existence of substantial kick-off and participating interest, prior to the amendments, are now required to be consolidated under the new guidelines. Since most securitization SPEs are VIEs, they will be consolidated under the new guidelines. This provision ensures that the users of financial statements will get a complete and consolidated view of the group, combining the gains/ losses the VIEs incur. US GAAP and International Financial Reporting Standards (IFRS) provisions affecting securitization As far as IFRS is concerned, the derecognition requirements have been traditionally elaborate and robust and have withstood the financial crisis of As a result, there have not been any significant changes to derecognition criteria after the financial crisis. The IFRS issued three new standards: IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements and IFRS 12Disclosure of Interests in other Entities. These new standards will be applicable to annual financial reporting periods beginning on or after 1 Jan 2013 and cover areas such as consolidation based on control and disclosure requirements with respect to unconsolidated structured entities. The IFRS disclosure requirements with respect to Financial Assets (IFRS 7) also underwent changes and additional disclosures were mandated. Let us now do a detailed comparison of derecognition, consolidation and disclosure criteria for financial assets under US GAAP and IFRS. Sr. IFRS US GAAP Remarks 1 Derecognition conditions apply at consolidated level after consolidation of subsidiaries and SPEs Derecognition conditions apply at consolidated level after consolidation of affiliates Both guidelines are similar in nature. 8
9 Sr. IFRS US GAAP Remarks 2 Derecognition conditions apply to an asset (or a group of similar financial assets) in its entirety or to a part of the asset (or a group of similar financial assets) 3 An entity should derecognize a financial asset when 1. Contractual rights to the cash flows from that asset, expire 2. It transfers the financial asset and the transfer complies with the derecognition criteria 3. An entity has substantially transferred all risks and rewards associated with the financial asset 4. The entity has neither transferred nor retained substantially the risks and rewards associated with the asset, it should determine if it has retained 'control' of the financial asset 4 In case an asset is transferred in its entirety, the resulting gain/ loss (difference between carrying value and net consideration received) needs to be recognized in P&L 5 In case a part of the asset is transferred, the carrying value of the original asset needs to be divided on the basis of relative fair values of the parts and the gain/ loss on the transferred part needs to be recognized in P&L Derecognition conditions apply to an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset An entity should derecognize the asset if it satisfies the following criteria: 1. Isolation of the financial asset 2. Ability of transferee to pledge/ exchange the transferred asset 3. Loss of effective control over the asset Codification standard describes the accounting, according to which, the resulting gain/ loss need to be recognized in earnings A describes the treatment the carrying value of the asset on the date of transfer needs to be divided between the participating interest sold and retained on the basis of their relative fair values Cash flows is the determining factor for identifying part of the assets under IFRS whereas the concept of participating interest has been introduced under US GAAP The requirements under both standards with respect to conditions for sale/ transfer, though not identical, are similar in essence and intent Both standards are similar Both standards are similar 9
10 Sr. IFRS US GAAP Remarks 6 If a transferred asset continues to be recognized, the asset and the associated liability should not be offset 7 Regular way sale (or purchase) of a financial asset shall be derecognized (or recognized) using trade date or settlement date accounting 8 Disclosures are covered under IFRS 7, and are quite detailed. No specific disclosures are required with respect to securitization transactions. IFRS 12 is applicable with reference to disclosure of interests in other entities i.e. subsidiaries, associates, joint arrangements and unconsolidated structured entities. The disclosures with respect to securitization SPEs are covered by this standard. 9 Consolidation of entities is covered under IFRS 10. An entity that controls other entities, needs to consolidate all such entities. Here control refers to rights to variable returns from involvement with the entity and the ability to affect those returns through power over the entity. Most SPEs will be consolidated with the transferor (of financial assets for the purpose of securitizing), under these provisions. Offsetting is covered under standard codification 810. US GAAP permits (does not mandate) offsetting if certain criteria are met. With reference to transferred financial assets that cannot be derecognized, there is no specific guidance regarding offsetting those assets with liabilities incurred becomes applicable and allows both trade date and settlement date accounting as per US GAAP Disclosures for such transactions are covered under standard codification , and are quite elaborate, requiring detailed disclosures with respect to each income statement, statement of financial position. Consolidation of entities is governed by codification standard 810. All entities over which an entity has controlling financial interest through voting power, contractual relationship, agreement with other stakeholders, leases etc., need to be consolidated. Power to control is not always evident from voting power. An entity has financial control over the other entity (VIE) if it has the ability to direct activities that impact the VIE s economic performance. Obligation to absorb losses and right to receive benefits are other indicators of financial control. Though there are subtle differences in requirements, in practice however, due to the nature of the transaction, accounting will be uniform under both standards. Both have similar provisions Disclosures under US GAAP are more elaborate as compared to those under IFRS and specifically address reporting of securitization activities The consolidation requirements are similar under IFRS and US GAAP. Most SPEs will have to be consolidated with the transferor of financial assets transferred for the purpose of securitization 10
11 Conclusion A careful consideration of the new accounting and reporting guidelines indicates that after the financial crisis, the US GAAP and IFRS have substantially aligned with respect to derecognition of financial assets and consolidation of entities. Although the requirements under both the standards are not exactly identical, they are similar in essence and intent. Accounting arbitrages in terms of erstwhile easy derecognition and flexible consolidation guidelines are no longer available. Securitization volumes have not picked up much since 2008 in the US or in Europe. Many factors such as negative perception of securitization as an investment class; the uncertain macroeconomic environment in a number of countries; concerns about the timing and content of regulation across sectors; unattractive yields relative to other debt market opportunities; illiquid secondary markets; and reduced confidence in ratings have played a major role in dampening securitization activities and volumes. In addition to the above factors, it is quite evident that the new stringent accounting standards/ guidelines have played an important role. As a result, private label securitization is no longer regarded as the clever financing tool it used to be, prior to the crisis. Steps taken by establishers of accounting standards such as FASB and the International Accounting Standards Board (IASB) will definitely help in instilling investor confidence in securitization transactions that take place. The detailed disclosures mandated by these bodies will bring about greater transparency of securitization transactions and their impact on the financial institutions income statements and balance sheets. 6. Basel Committee on Banking Supervision Joint Forum Report on Asset Securitization Incentives, July 2011 References [1] Jonathan C. Lipson, Why (and How to) define Securitization, [2] IMF, Global Financial Stability Report(GSFR), Oct 2009 [3] SIFMA, Global Securitization update, 2012 [4] Bank for International Settlements (BIS),The Joint Forum Report- Asset Securitization Incentives, July 2011 [5] Social Science Research Network, Jonathan C. Lipson- Defining Securitization,January
12 Contact For more information, contact Subscribe to TCS White Papers TCS.com RSS: Feedburner: About Tata Consultancy Services (TCS) Tata Consultancy Services is an IT services, consulting and business solutions organization that delivers real results to global business, ensuring a level of certainty no other firm can match. TCS offers a consulting-led, integrated portfolio of IT and IT-enabled infrastructure, engineering TM and assurance services. This is delivered through its unique Global Network Delivery Model, recognized as the benchmark of excellence in software development. A part of the Tata Group, India s largest industrial conglomerate, TCS has a global footprint and is listed on the National Stock Exchange and Bombay Stock Exchange in India. For more information, visit us at IT Services Business Solutions Consulting All content / information present here is the exclusive property of Tata Consultancy Services Limited (TCS). The content / information contained here is correct at the time of publishing. No material from here may be copied, modified, reproduced, republished, uploaded, transmitted, posted or distributed in any form without prior written permission from TCS. Unauthorized use of the content / information appearing here may violate copyright, trademark and other applicable laws, and could result in criminal or civil penalties. Copyright 2013 Tata Consultancy Services Limited TCS Design Services I M I 05 I 13
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