Securitization Accounting The Ins and Outs (and some Do s and Don ts) of FAS 166, 167, and Counting...

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1 Securitization Accounting The Ins and Outs (and some Do s and Don ts) of FAS 166, 167, and Counting... Marty Rosenblatt, Jim Mountain, and Ann Kenyon Eighth Edition January 2010

2 Contents Chapter 1 What are FAS 166 and 167 and when do they apply? 4 Chapter 2 Who has to consolidate the special purpose entity? 6 Chapter 3 How do you determine whether a securitization meets the sale criteria? 18 Chapter 4 Do I always need to bother my lawyer for an opinion letter? 29 Chapter 5 How about some examples? 34 Chapter 6 How will taxes affect my transaction? 43 Chapter 7 How do you determine gain or loss on a sale? 58 Chapter 8 How do I measure and report fair value information? 67 Chapter 9 What are some of the investor accounting issues? 72 Chapter 10 Can banks get regulatory capital relief through securitization? 81 Chapter 11 How do securitizations fare under international accounting standards? 89 Chapter 12 So where is the transparency? 102 Chapter 13 Regulation AB and a look into the reporting future 113 Appendix Solving the securitization puzzles 121 ACCOUNTANT GENERAL S WARNING: This publication contains information as of January 15, Certain aspects of this publication may become outdated due to subsequent development of guidance and interpretations. Relying on this booklet is not a safe alternative to staying abreast of and carefully evaluating current authoritative guidance and interpretations. Using obsolete accounting, tax or regulatory guidance may prove hazardous to your financial health.

3 What s new in 2010? Is off-balance sheet treatment still VIE-able? I have been writing about securitization accounting for 25 years. There has never been a time when so many pillars of the securitization process have been tossed up in the air without an indication as to how they will land. Even in the face of the most comprehensive changes in over a decade, presented in the form of FAS 166 and 167, securitization accounting will continue to evolve. Inevitably, as the industry rebuilds, structures will change and the accounting guidance will also inevitably change. In the midst of these interesting times, having just completed with my colleagues this eighth edition... it is now time to pass the torch to them. They are strong in number as well as in talent, having studied under a master sensei. Some are saying that the slaying of the Q will bring virtually all deals on-balance sheet and the art of securitization accounting is no longer a subject worth writing about. I disagree. As always, accounting issues will continue to play a significant role in securitizations. First, not all deals will be consolidated. And, when they are, it is not always easy to decide who should consolidate and when. Also, accounting for a securitization as a financing does not eliminate the need to make subjective judgments and estimates and could still result in significant volatility in earnings due to the usual factors of prepayments, credit losses, and interest rate movements. After peeling back the consolidated assets and liabilities, the company still owns what is in effect a residual even though it cannot be found that way on the balance sheet. You, like us, might not think that FAS 166 and 167 is a perfect solution. But, by nature, no accounting standard is ever perfect for all financial statement preparers and users. You can t please all of the people any of the time. Securitizations are neither fish nor fowl. They are not a pristine sale and they are not an IOU financing. That is why I have been passionate over the years calling for a linked presentation solution where the non-recourse liabilities are deducted from the securitized assets on the asset side of the balance sheet. Perhaps there is still hope for that. The FASB and the IASB recently agreed to propose joint guidance on sale accounting and consolidation sometime later this year. In my opinion, it is likely to take longer and I ve won many bets over the years taking that side of the proposition The earliest editions of this booklet were hardly more than a pamphlet. Over the years, we have added coverage of taxes, bank capital regulations, Regulation AB, international accounting standards, and some light-hearted quizzes and puzzles. We have always strived to write this booklet to be useful to a broad range of potential readers, not just practicing accountants. After all, we learn the most about securitization from the wonderful relationships and ongoing dialogue we have with all the constituents in the securitization community; those conversations with you continue to be of paramount importance to us. After perusing this booklet, you might be convinced that a fundamental disconnect and substantial uncertainty exists among law, economics, securities and bank regulation, tax rules, and accounting for future securitizations. You are correct. Even if the accounting issues stabilize, at least for 2010, expect important new rules this year from the SEC, bank regulators, Congress, and others, along with reforms internationally. I hope you find this booklet useful in your business endeavors it is not fit for a coffee table or wedding present! Cheers, Martin J. Rosenblatt January

4 Chapter 1 Let s start at the beginning: What are FAS 166 and 167 and when do they apply? Easy. FAS considers whether securitizations and other transfers of financial assets are treated as sales or financings. It also covers the accounting for servicing. FAS 167 addresses whether certain legal entities often used in securitization and other structured finance transactions should be included in the consolidated financial statements of any particular interested party. Together, these two standards determine the extent to which a securitization transaction is on or off the financial statements of originators, servicers, and investors. If you are looking for a comprehensive reference resource for FAS 166 and FAS 167, or even a basic primer on them, you ve come to the wrong place. This booklet only deals with securitization. So, for example, we do not cover the substantive portions of FAS 166 dealing with repos, securities lending, and debt extinguishments. Also, we do not cover the substantive portions of FAS 167 that tell you how to decide if a special purpose entity (SPE) is a variable interest entity (VIE); we just concede that a securitization SPE is going to be a VIE. These standards apply to: Public and private companies that follow accounting principles generally accepted in the United States of America (U.S. GAAP or GAAP), including foreign companies that follow U.S. GAAP Public and private offerings All transfers of financial assets Resecuritizations of existing ABS, MBS, CMBS and CDO classes FAS 166 does not apply to: Transfers of nonfinancial assets (or unrecognized financial assets) such as operating lease rents, unguaranteed lease residuals from capital leases, servicing rights, stranded utility costs, or sales of future revenues such as entertainers royalty receipts Assets used as reference pools in synthetic securitization structures Income tax sale versus borrowing characterizations or gain/loss calculations for tax purposes Statutory accounting or risk-based capital rules for insurance companies 2 4 Securitization accounting 1 In June, 2009, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an amendment to Statement of Financial Accounting Standards No. 140, and Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R). For simplicity, we will refer to the resulting guidance as amended, simply as FAS 166 and FAS 167, respectively. The FASB has also codified all of its current accounting guidance in a standardized format in its Accounting Standards Codification. When a more specific reference is required, we will use citations from the Codification, unless otherwise indicated. For example, the first paragraph of the Codification Topic on Accounting for Transfers of Financial Assets would be cited in the brackets following this sentence. [ ] The Codification Topic covering consolidation generally, including VIEs, is Topic 810. In order to facilitate the transition to codification, we have inserted the applicable paragraph number from FAS 166 and/or FAS 167 in braces (e.g., {par. 9b}) but such references are no longer considered to be authoritative. 2 At the time of this writing, the Statutory Accounting Principles Working Group of the National Association of Insurance Commissioners has issued exposure drafts proposing adoption, with modifications, of FAS 166 to supersede SAP No. 91R (Issue Paper No. 141, ) and proposing requirements for identification, documentation and disclosure (but not consolidation) of variable interests in variable interest entities (Issue Paper No. 142, ).

5 FAS 167 does not apply to: Most not-for-profit and governmental entities Employee benefit plans not being consolidated by their employer sponsor Investment companies, who have an exemption from consolidating investments they carry at fair value (but it might be germane to deciding when an investor or adviser should consolidate an investment company, in particular in light of a special deferral of the adoption of FAS 167 for certain entities) Life insurance companies accounting for separate accounts Many foreign private issuers and other non-u.s. companies follow International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). See Chapter 11 How do securitizations fare under international accounting standards for a more in-depth discussion. Guidance provided by the IASB may result in completely different accounting treatment for securitizations than transactions accounted for under FAS 166 and 167. Both the FASB and the IASB are actively working to align U.S. and international accounting standards in many areas. When it comes to securitizations however, that convergence may be several years in arriving; importantly, though, the issuance of FAS 166, in particular with its elimination of the QSPE concept and its limitation on the portion of financial assets eligible for derecognition, has moved the guidance promulgated by both sets of standards closer to convergence. Chapter 1 5

6 Chapter 2 Who has to consolidate the special purpose entity? That is the question! In accounting for securitizations, there are two baseline questions to be answered: 1) Do I have to consolidate the special purpose entity(ies) involved? 2) Have I sold the transferred assets for accounting purposes? Traditionally, accountants have looked to answer the sale question first, but with the issuance of FAS 166 and 167, the order of the analysis has been reversed, with the question of consolidation addressed initially, and then, if still in the running, the sale question. Even if all of the other sale accounting conditions of FAS 166 are met with respect to a particular transfer, if the transferee is to be consolidated by the transferor, then the transferred financial assets will not be treated as having been sold by the transferor, at least in its consolidated financial statements. Because many securitizations involve more than one transfer and consolidated affiliates often prepare their own separate company financial statements, the consolidation and sale questions will often need to be considered more than once for a transaction. As one might expect, different answers may be appropriate at different stages in the securitization or for different financial reporting purposes. When do the new rules apply? Both FAS 166 and 167 become effective at the beginning of the first fiscal year that begins after November 15, For calendar year-end companies, that was January 1, 2010, and hopefully they have already figured out their transition. That is why the rest of this booklet is forward looking, rather than dwelling on one-time transition rules. The FASB has issued an Exposure Draft proposing to provide a deferral from the application of FAS 167 for a limited number of types of entities, including, but not limited to, mutual funds, hedge funds, mortgage real estate investment trusts, private equity funds, and venture capital funds until the FASB and IASB jointly decide what s best. However, before you get too excited, the FASB has gone out of its way in the Exposure Draft to say that it expects that this deferral would not apply to securitization entities, asset-backed financing entities, entities formerly classified as qualifying special purpose entities, structured investment vehicles, collateralized debt/loan obligations, commercial paper conduits, credit card securitization structures, residential or commercial mortgage-backed entities, and governmentsponsored mortgage entities. Stay tuned to see if the final amendment (expected to be issued shortly after this booklet) widens (or narrows) the scope of the deferral. 6 Securitization accounting

7 Special purpose entity/variable interest entity what s the difference? FAS 167 governs consolidation of VIEs. Not all SPEs are VIEs, but substantially all securitization SPEs are VIEs. A VIE does not issue voting interests (or other interests with similar rights) with the power to direct the activities of the entity and often the total equity investment at risk is not sufficient to permit the entity to finance its activities without additional forms of credit enhancement. If an entity does not issue voting or similar interests or if the equity investment is insufficient, that entity s activities probably are predetermined or decision-making ability is determined contractually. Since securitization SPEs are rarely designed to have a voting equity class possessing the power to direct the activities of the entity, they are VIEs. The investments or other interests that will absorb portions of a VIE s expected losses or receive portions of its expected residual returns are called variable interests. Who must consolidate a VIE? One of the outcomes of applying the guidance in FAS 167 is that there are participants in common securitization structures who may end up consolidating the issuer SPE even if they were not the original transferor of the financial assets. Because most securitization SPEs are VIEs, the first step in determining which enterprise might win the consolidation prize is, logically enough, identifying all the parties to the deal and identifying which ones have a variable interest. While there is no requirement for the transaction parties to compare their accounting conclusions, each participant needs to understand the various rights and obligations granted to each party in order to conclude as to its own accounting for its interest in the issuer VIE. Only substantive terms, transactions, and arrangements, whether contractual or noncontractual, shall be considered. Any term, transaction, or arrangement that does not have a substantive effect on (a) an entity s status as a variable interest entity, (b) an enterprise s power over a variable interest entity, or (c) an enterprise s obligation to absorb losses or its right to receive benefits of the entity shall be disregarded. Judgment, based on consideration of all facts and circumstances, is needed to distinguish substantive terms, transactions, and arrangements from nonsubstantive ones. [ A] The SEC Chief Accountant also told auditors and preparers to remain vigilant when evaluating the substance, or lack thereof, of elements of transactions included to achieve specific accounting results for off-balance sheet transactions. The entity, if any, that consolidates a VIE is called its primary beneficiary (PB). A PB has what is described as a controlling financial interest. You are deemed to have a controlling financial interest in a VIE if you have variable interests with both of the following characteristics: a. the power to direct the activities of a VIE that most significantly impact the VIE s economic performance b. the obligation to absorb losses of the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. [ A] Only one reporting entity, if any, is expected to be the PB. Although several deal participants could have the characteristics in (b) above, only one, if any, will have the power to direct the activities that most significantly impact the VIE s economic performance. Further discussion on interpreting what it takes to have variable interests that are potentially significant to the VIE is provided later in this chapter. Chapter 2 7

8 Consolidation decision process Do I have: a variable interest a in the VIE? No Yes power to direct activities that most significantly impact economic performance? Yes an obligation to absorb losses (or right to receive benefits) that could potentially be significant? Yes controlling financial interest No No I am the primary beneficiary VIE is not consolidated by me VIE is consolidated by me a Some servicing fee and decision-maker arrangements may not constitute a variable interest in a VIE. See Fees paid to decision makers or service providers that follows. Consolidation is an all or nothing proposition. If a VIE must be consolidated, 100 percent of its assets and all of its liabilities (to third parties) are included in the consolidated balance sheet of the PB, not just the PB s proportionate ownership share. Identifying the most important activity In securitizations, the economic performance of the entity is generally most significantly impacted by the performance of the underlying assets. Sometimes, in structures like CP conduits, management of liabilities (for example, selecting the tenor of CP) will also significantly impact the performance of the entity. Some of the factors that might impact the performance of the underlying assets might be beyond the direct control of any of the parties to the securitization, like voluntary prepayments, and therefore don t enter into the power analysis. The activity that most significantly impacts the performance of the underlying assets is typically the management by the servicer of the inevitable delinquencies and defaults that occur or, in a managed CDO, the activities of the collateral manager in selecting, monitoring, and disposing of collateral securities. 8 Securitization accounting When analyzing who has the power to direct those activities, questions that have to be answered include: Do I hold the power unilaterally? Or do other parties also have relevant rights and responsibilities? For example: Is there another party that has to consent to every important decision? Is there another party who can direct me to take certain actions? Is there another party who can replace me without cause? Is there another party or other parties that direct the same activities as me, but with a different portion of the trust s assets?

9 Is there another party or other parties that direct other important activities of the trust? Which activities are the most important? And, is my right to exercise power currently available or contingent on some other event(s) occurring? Situation When Might a Servicer or Collateral Manager not be the Primary Beneficiary? The servicer earns a fixed fee at a market rate and has no other financial interest in the deal The activities of the servicer are administrative in nature and there is a special servicer The servicer can be replaced without cause by a single unrelated party All important servicing decisions require the consent of one or more unrelated parties The servicer services less than a majority of the assets in the VIE See related guidance topic below Fees paid to decision makers or service providers Special Servicers Kick-out rights Participating rights and shared power Multiple parties having power Fees paid to decision makers or service providers It is possible for a servicer or other decision maker to have the power to direct the activities that most significantly impact the economic performance of the VIE, but for the servicer not to have a variable interest in the VIE. If a servicer or other decision maker can meet ALL of the following six conditions ( ), 3 then the arrangement will not be considered a variable interest in a VIE, and the servicer will not consolidate. The objective of the tests is to determine whether the service provider is acting in a fiduciary (agency) role as opposed to acting as a principal. If, as is often the case, the servicer also owns some of the securities issued by the VIE, you should probably skip this section. The conditions in {par. B22} are: a. The fees are compensation for services provided and are commensurate with the level of effort required to provide those services. b. Substantially all of the fees are at or above the same level of seniority in the waterfall on distribution dates as other expenses of the entity. c. The decision maker or service provider and its related parties, if any, do not hold other interests in the variable interest entity that individually, or in the aggregate, would absorb more than an insignificant amount of the VIE s expected losses or receive more than an insignificant amount of the VIE s expected residual returns. d. The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arm s length. e. The total amounts of anticipated fees are insignificant relative to the total amount of the VIE s anticipated economic performance. f. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIE s anticipated economic performance. 3 The FASB has issued an Exposure Draft proposing to amend the original source of that guidance, which is {par. B22}. The amendments, if finalized in their current form, would state that entities should consider related parties when evaluating the conditions under paragraph B22 as well as that a quantitative approach to expected losses and expected residual returns is not required and is not the sole determinant in an entity s evaluation under (c) {par.b22 (c)}. Finalization is expected shortly after this booklet is published. Chapter 2 9

10 If the fees paid to decision makers or service providers do not meet all of the conditions above, then those fees are variable interests and the decision maker or service provider would proceed to the next steps in the consolidation decision process chart on page 8. The decision maker must also determine whether that variable interest is a variable interest in the VIE as a whole, or whether it relates to particular specified assets of the VIE. If the variable interest relates to assets representing more than the majority of the assets within the VIE, or if the decision maker holds another variable interest in the entity as a whole, then it would be deemed to be a variable interest in the VIE and the decision maker or service provider would proceed to the next steps in the same chart. The use of the term insignificant in conditions c, e, and f above is discussed in further detail later in this chapter. Special servicers In CMBS, and perhaps additional asset classes going forward, it is common that upon delinquency or default by the borrower or when default is reasonably foreseeable, the responsibility for servicing of the loan is transferred from the primary servicer to a special servicer. In such cases, the activities that the primary servicer has the power to direct are typically administrative in nature and do not significantly impact the entity s economic performance. Thus, the primary servicer would not typically be the primary beneficiary. But can the special servicer be the PB even at the outset of the transaction given that there were no loans in special servicing? Yes. Since the activities performed by the primary servicer are not considered significant to the economic performance of the VIE and it is considered likely that the special servicer will be performing services during the life of the VIE, the special servicer is considered from the outset to have the power to direct the activities that are most significant. See later section on Power to direct, contingent on other events. Kick-out rights If a single participant has the substantive right to unilaterally remove the party that directs the entity s most significant activities, that right, in and of itself, may support the fact that the holder of the kick-out right has power over the VIE, but only if that right is substantive, can be exercised even in the absence of a breach of contract or insolvency by the service provider and is held by a single enterprise. For example, it is common in CMBS transactions, for a controlling classholder, who is defined in the transaction documents as the party who holds the majority of the most subordinated class of the issuer s securities, to be able to remove the special servicer in the transaction without cause. In many cases, the controlling classholder is the same as or affiliated with the special servicer, so this provision would not have an effect on the PB analysis in those situations. If a vote of the holders of the subordinated class of the issuer s securities was needed in order to replace the service provider, and it takes two or more unrelated parties to carry the vote, then the kick-out right would have to be ignored by the service provider. Furthermore, replacement of a servicer only upon breach of contract or insolvency is considered a protective right, not a participating right see section that follows. A kick-out right would generally be considered substantive if there are no significant barriers to the exercise. Barriers to exercise include, but are not limited to: Conditions that make it unlikely they will be exercisable, for example, conditions that narrowly limit the timing of the exercise 10 Securitization accounting

11 Financial penalties or operational barriers associated with replacing the decision maker that would act as a significant disincentive for removal The absence of an adequate number of qualified replacement decision makers or inadequate compensation to attract a qualified replacement Participating rights and shared power Participating rights are the ability to block the actions through which an enterprise exercises the power to direct the activities of a variable interest entity that most significantly impact the entity s economic performance. [ ] If a single participant can veto all important decisions made by the servicer, that right, if considered substantive, might cause the service provider to not have the power. If, in addition to being able to veto servicer decisions, a single participant could direct the servicer on what actions to take on defaulted loans, the consolidation burden might shift to that single participant. It is unusual in securitization transactions for any single participant to have the ability to block servicer actions, other than in certain limited cases, when a monoline insurer is paying out losses. This may cause a shift in power. See the sections on Reconsideration of primary beneficiary and Power to direct, contingent on other events on page 16. The requirement to obtain consent is considered substantive when the consent is required for all of the activities that most significantly impact the entity s economic performance. When the consent relates only to activities that are unimportant or only to certain of the significant activities, the consent would not be considered substantive and power would not be considered shared. In addition, an enterprise would need to closely analyze the governance provisions of an entity to evaluate whether the consent requirements are substantive (e.g., the consequences if consent were not given). Multiple parties having power The concept of multiple parties having power can manifest itself in two ways: 1) Multiple parties performing different activities 2) Multiple parties performing the same activities Chapter 2 11

12 Multiple parties performing different activities It is possible that in certain securitizations, one service provider might be engaged to perform asset management and another service provider to perform funding management. In those situations, one must determine which activity most significantly affects the economic performance of the entity. Judgment will be required based on an analysis of all of the facts and circumstances. Multiple parties performing the same activities Consider a securitization issued by an investment bank SPE that purchased assets with the servicing retained by the originator. The SPE issues securities backed by a commingled pool of assets acquired from multiple originator/servicers. A master servicer is engaged to aggregate collections and perform investor reporting but does not direct the default management by the individual primary servicers. If none of the individual servicers service the majority of the assets, then no party directs the activities that have the most significant impact on the economic performance of the entity. The FASB did not provide guidance on whether majority should be based on the dollar amount or number of loans, but since the measure is economic performance of the entity, we believe that dollar amount should be the base. Keep in mind that while no servicer might be servicing a majority of the assets at inception, that could change over time if prepayment experience differs between the various servicers. FAS 167 does not illustrate a situation in which the credit quality of any of the loan pools differs substantially enough from the other pools such that servicing of those loans might constitute more significant activities. When might decision maker fees be considered insignificant, and thus not a variable interest? As a general guideline, we believe that if the variability absorbed through the fee arrangement or other variable interests in the VIE exceeds, either individually or in the aggregate, 10 percent of the expected losses or expected residual returns of the VIE, the conditions in items c and f above are not met and the decision-maker or service-provider fee would therefore, be considered a variable interest. The same general guideline can be applied to the evaluation under item e above of the total amount of anticipated fees to be received by a decision maker or service provider in comparison to the total anticipated economic performance of the VIE. However, 10 percent should not be viewed as a bright-line or safe harbor definition of insignificant. 12 Securitization accounting

13 The analysis under items c, e, and f deals with the expected (or anticipated) outcome of the VIE. Therefore, when analyzing a decision-maker or service-provider fee under these paragraphs, an enterprise would identify and weigh the probability of various possible outcomes in determining the expected losses, expected residual returns, and anticipated economic performance of the VIE. However, it is not expected that an entity will always need to prepare a detailed quantitative analysis to reach a conclusion as to insignificance. Potentially significant A decision-maker or service-provider fee is often a variable interest under {par. B22} because the enterprise concludes that its fee and other variable interests in the entity represent a more than insignificant economic interest in the entity. There may be situations in which a party with a variable interest will not have a right to receive benefits from the VIE or the obligation to absorb losses of the VIE that could potentially be significant to the VIE. For example, a service provider s right to receive a fixed fee may represent a variable interest but will not always represent a benefit or obligation that could potentially be significant to the VIE. This is discussed in the basis for conclusions in FAS 167, which notes that the servicer may be able to conclude, on the basis of the magnitude of the fixed percentage, that the fee could not ever potentially be significant to the entity because the fee would remain a constant percentage of the entity s assets. On the other hand, a fee that was considered insignificant under s {par. B22 s} probability notion might be considered potentially significant under A s {par. 14A(b) s} possibility notion as discussed below. [ A] FAS 167 does not define economic performance, but it does indicate that an enterprise must assess the VIE s purpose and design when evaluating the power to direct the activities of the VIE. This assessment includes a consideration of all risks and associated variability that are absorbed by any of the VIE s variable interest holders. However, the quantitative calculations of expected losses and expected residual returns are not required. An enterprise should not consider probability when determining whether it meets the condition in A {par. 14A(b)}. Therefore, even a remote possibility that an enterprise could absorb losses or receive benefits that could be significant to the VIE causes the enterprise to meet the A {par. 14A(b)} condition. A relatively small first-loss piece might not have the potential to absorb a significant amount of losses but might have the potential to receive significant benefits. On the other hand, a large senior class might not have the potential to receive significant benefits because the interest is capped, but has the potential to absorb more losses than the smaller subordinated classes. In a speech at the 2009 American Institute of Certified Public Accountants (AICPA) SEC Conference, Professional Accounting Fellow Arie Wilgenburg remarked: So what is a significant financial interest? Well, Statement 167 describes such an interest as one that either obligates the reporting enterprise to absorb losses of the entity or provides a right to receive benefits from the entity that could potentially be significant. That description leaves us with an important judgment to make regarding what could potentially be significant. In the past few weeks, the staff has been thinking about this concept. While there is no bright-line set of criteria for making this assessment, I thought it would be helpful to provide some thoughts in this area. Chapter 2 13

14 First, similar to how we have talked in the recent past about materiality assessments being based on the total mix of information, we believe that assessing significance should also be based on both quantitative and qualitative factors. While not all-inclusive, some of the qualitative factors that you might consider when determining whether a reporting enterprise has a controlling financial interest include: 1) The purpose and design of the entity. What risks was the entity designed to create and pass on to its variable interest holders? 2) A second factor may be the terms and characteristics of your financial interest. While the probability of certain events occurring would generally not factor into an analysis of whether a financial interest could potentially be significant, the terms and characteristics of the financial interest (including the level of seniority of the interest) would be a factor to consider. 3) A third factor might be the enterprise s business purpose for holding the financial interest. For example, a trading-desk employee might purchase a financial interest in a structure solely for short-term trading purposes well after the date on which the enterprise first became involved with the structure. In this instance, the decision making associated with managing the structure is independent of the short-term investment decision. This seems different from an example in which a sponsor transfers financial assets into a structure, sells off various tranches, but retains a residual interest in the structure. As previously mentioned, this list of qualitative factors is neither all-inclusive nor determinative and the analysis for a particular set of facts and circumstances still requires reasonable judgment. Are related parties aggregated for purposes of identifying a controlling financial interest? FAS 167 does address the situation where a related group of entities, including the enterprise and its related parties (including its de facto agents), meets both requirements, but no one member of the group does individually. When that happens, the entity within the related party group that is most closely associated with the SPE gets the honor of representing the group as the primary beneficiary that consolidates the VIE. [ ] What about transactions like RE-REMICs? Are there situations in which VIEs will not have ongoing activities that significantly affect their economic performance? Yes. In limited situations, the ongoing activities performed throughout the life of a VIE, though they may be necessary for the VIE s continued existence (e.g., administrative activities in certain resecuritization entities, such as RE-REMICs), may not be expected to significantly affect the VIE s economic performance. In such situations, determination of the primary beneficiary will need to focus on the activities performed and decisions made at the VIE s inception as part of the VIE s design, because in these situations the initial design had the most significant impact on the economic performance of the VIE F {par. 14F} states, in part, that an enterprise s involvement in the design of a VIE may indicate that the enterprise had the opportunity and the incentive to establish arrangements that result in the enterprise being the variable interest holder with the power to direct the activities that most significantly impact the VIE s economic performance. However, this paragraph also notes that involvement in design does not, in itself, establish that enterprise as the party with power. In many situations, several parties will be involved in the design of a VIE and an analysis of the decisions made 14 Securitization accounting

15 as part of the design would not be determinative or would not result in the identification of a primary beneficiary. [ F] G {par. 14G} states, in part: Consideration should be given to situations in which an enterprise s economic interest in a variable interest entity, including its obligation to absorb losses or its right to receive benefits, is disproportionately greater than its stated power to direct the activities of a variable interest entity that most significantly impact the entity s economic performance. This may be an indication that the ongoing activities of an entity are not expected to significantly affect its economic performance. In such situations, the power analysis would most likely focus on the decisions made at the entity s inception as part of the design of the entity. [ G] Thus, in situations in which the ongoing activities of a VIE are not expected to significantly affect the entity s economic performance and one enterprise (or related-party group) holds an economic interest that is so significant that the other interest holders, as a group, do not hold more than an insignificant amount of the fair value of the entity s interests or those interests do not absorb more than an insignificant amount of the entity s variability, it would generally be appropriate to conclude that the enterprise (or an enterprise within the related-party group) with that significant economic interest made the decisions at the inception of the VIE or that the decisions were essentially made on the enterprise s behalf. Therefore, in such situations, it would be appropriate to conclude, after all facts and circumstances associated with the VIE have been considered, that the enterprise (or the enterprise within the related-party group) has a controlling financial interest in the entity. In addition, when analyzing the design of a VIE whose ongoing activities are not expected to significantly affect its economic performance, an enterprise should use judgment to determine whether the economic interest of an enterprise (or related-party group) is so significant that it suggests the decisions made during the design of the VIE were made by that enterprise (or related-party group) or were made on its behalf. Note that when the primary-beneficiary analysis is based solely on the design of an entity, the determination of whether one enterprise (or related-party group) absorbs all but an insignificant amount of the variability in an entity depends, in part, on a consideration of the entity s expected losses and expected residual returns. By focusing on expected losses and expected residual returns, a party with a small overall ownership percentage in an entity could be exposed to a significant amount of an entity s variability (e.g., the holder of a residual interest when there is a large amount of senior interests). Similarly, a party with a large overall ownership percentage in an entity may not be exposed to a significant amount of an entity s variability (e.g., if the party holds senior interests in an entity whose capitalization also includes substantive subordinated and residual interests). In resecuritizations in which there are multiple underlying asset groups with no cross-collateralization, these determinations are made on a group-by-group basis, since each group would be considered a silo and treated for accounting purposes as a separate VIE. Chapter 2 15

16 Reconsideration of the primary beneficiary FAS 167 requires that an enterprise continually reconsider its conclusion regarding which interest holder is the VIE s primary beneficiary. Because continual reconsideration is required, the securitization transaction participant will need to determine when, during the reporting period, the change in primary beneficiary occurred. If a deal party determines that it is no longer the primary beneficiary of a VIE, it would need to deconsolidate that particular VIE on the date that the circumstances changed and recognize gain or loss. Power to direct, contingent on other events When a party can direct activities only upon the occurrence of a contingent event, the determination of which party has power will require an assessment of whether the contingent event results in a change in power (i.e., power shifts from one party to another upon the occurrence of a contingent event) over the most significant activities of the entity (in addition, the contingent event may change what the most significant activities of the entity are) or whether the contingent event initiates the most significant activities of the entity (i.e., the entity s most significant activities only occur when the contingent event happens). Determining whether the contingent event results in a change in power over or initiates the most significant activities of the entity will be based on a number of factors, including: The nature of the activities of the VIE and its design. The significance of the activities and decisions that must be made before the occurrence of the contingent event, compared with the significance of the activities and decisions that must be made once the contingent event occurs. If both sets of activities and decisions are significant to the economic performance of the entity, the contingent event results in a change in power over the most significant activities of the entity. However, if the activities and decisions before the contingent event are not significant to the economic performance of the entity, the contingent event initiates the most significant activities of the entity. If a transaction participant concludes that the contingent event initiates the most significant activities of the entity, all of the activities of the VIE (including the activities that occur after the contingent event) would be included in the evaluation of whether the deal party has the power to direct the activities that most significantly affect the VIE s economic performance. In such instances, the party that directs the activities initiated by the contingent event would be the enterprise with the power to direct the activities that most significantly affect the economic performance of the VIE. See earlier section on Special servicers. If the transaction participant concludes that the contingent event results in a change in power over the most significant activities of the SPE, the deal party must evaluate whether the contingency is substantive. This assessment should focus on the entire life of the VIE. Some items to consider in assessing whether the contingent event is substantive include: The nature of the activities of the VIE and its design. The terms of the contracts the VIE has entered into with the variable interest holders. The variable interest holders expectations regarding power at inception of the arrangement and throughout the life of the entity. Whether the contingent event is outside the control of the variable interest holders of the VIE. The likelihood that the contingent event will occur (or not occur) in the future. This should include, but not be limited to, consideration of history of whether a similar contingent event in similar arrangements has occurred. 16 Securitization accounting

17 Consider, for example, the role of a monoline insurer who has guaranteed the senior class of a securitization against losses once all subordinated classes have been written down to zero. In certain transactions, upon the occurrence of such events, the power of the monoline insurer increases in ways such as the ability to replace the servicer or to start directing the servicer in the actions it should take on defaulted loans. The occurrence of the contingent event would likely result in a change in power over the most significant activities of the VIE and a change in PB. Another example would be the controlling classholder in a securitization initially being the holder of the majority of the most subordinated class. However, if losses are such that the subordinated class is reduced below some prespecified level, then the controlling classholder is changed to the holder of the majority of the next class (e.g., a mezzanine class). The occurrence of the contingent event might result in a change in power and a change in PB. Sarbanes-Oxley internal control over financial reporting for consolidated VIEs At the 2009 AICPA SEC Conference, Professional Accounting Fellow Doug Besch discussed the impact of a registrant s consolidation of VIEs upon adopting FAS 167 on management s report on internal control over financial reporting (ICFR). He noted that the staff s FAQs 4 address situations in which registrants could potentially exclude certain VIEs from management s reports on ICFR. However, Mr. Besch stated that registrants will be expected to include VIEs consolidated upon adoption of FAS 167 in management s reports on ICFR, since the staff believes that registrants will likely have the right or authority to assess the internal controls of the consolidated entity, and since the consolidation will occur as of the first day of the fiscal year, registrants will have sufficient time to perform that assessment. 4 Management s Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports Frequently Asked Questions, which was released by the SEC staff in September Chapter 2 17

18 Chapter 3 How do you determine whether a securitization meets the sale criteria? When is a securitization accounted for as a sale? People often describe a securitization as being either a sale or a financing, and the FASB has confirmed that is the intended result of the new guidance articulated in FAS 166. More specifically, FAS 166 stipulates that transfer 5 of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset needs to be evaluated for relinquishment of control over those transferred assets. For the discussion on what constitutes an entire financial asset, pool of assets, or a participating interest, please see What is an entire financial asset? on page 28. In performing this evaluation, the question to be answered is whether a transferor, and its consolidated affiliates included in the financial statements being presented, has surrendered control over the transferred financial assets. Thus, it is important for the transferor to complete its analysis with respect to the securitization SPE s consolidation prior to evaluating the transfer of financial assets for its conformity with the requirements for sale treatment. In reaching a determination, facts such as the transferor s or any of its consolidated affiliates continuing involvement with the transferred assets, as well as other arrangements between the parties to the transaction that were entered into either contemporaneously with, or in contemplation of, the transfer must be considered in the analysis. [ ] Sale criteria A securitization of a financial asset, a participating interest in a financial asset, or a pool of financial assets in which the transferor (a) surrenders control over the assets transferred and (b) receives cash or other proceeds is accounted for as a sale. Control is considered to be surrendered in a securitization only if all three of the following conditions are met: (1) the assets have been legally isolated; (2) the transferee has the ability to pledge or exchange the assets; and (3) the transferor otherwise no longer maintains effective control over the assets. Each of these requirements is discussed further below: a. Legal isolation [ ] The transferred assets have to be isolated put beyond the reach of the transferor, or any consolidated affiliate of the transferor, and their creditors (either by a single transaction or a series of transactions taken as a whole) even in the event of bankruptcy or receivership of the transferor or any consolidated affiliate {par. 9a}. This is a facts and circumstances determination, which includes judgments about the kind of bankruptcy or other receivership into which a transferor or affiliate might be placed, whether a transfer would likely be deemed a true sale at law, and whether the transferor is affiliated with the transferee. In contrast to the going concern convention in accounting, the transferor must address the possibility of bankruptcy, regardless of how remote insolvency may appear given the transferor s credit standing at the time of securitization. Even a AAA sponsor of a securitization must take steps to isolate its assets. It is not enough for the transferor merely to assert that it is unthinkable that a bankruptcy situation could develop during 5 For accounting purposes, the term transfer has a very specific meaning. It relates to non-cash financial assets only and involves a conveyance from one holder to another holder. Examples include selling a receivable, pledging it as collateral for a borrowing or putting it into a securitization vehicle. The definition excludes transactions with the issuer or maker of the financial instrument, such as originating a receivable, collecting it or restructuring it, such as in a troubled debt restructuring. 18 Securitization accounting

19 the relatively short term of the securitization. Certainly, the recent disarray of the financial markets has highlighted the fact that unexpected bankruptcies of formerly investment-grade companies can happen. Consider the typical two step securitization structure: STEP 1: The seller/company transfers assets to a special purpose entity that, although wholly owned, is designed in such a way that the possibility that the transferor or its creditors could reclaim the assets is remote. This first transfer is designed to be judged a true sale at law, in part, because it does not provide excessive credit or yield protection to the SPE. STEP 2: The SPE transfers the assets to a trust or other legal vehicle with a sufficient increase in the credit and yield protection on the second transfer (provided by a subordinated retained beneficial interest or other means) to merit the high credit rating sought by investors. The second transfer may or may not be judged a true sale at law and, in theory, could be reached by a bankruptcy trustee for the SPE. However, the first SPE s charter forbids it from undertaking any other business or incurring any liabilities, thus removing concern about its bankruptcy risk. The charter of each SPE must also require that the company be maintained as a separate concern from the parent to avoid the risk that the assets of the SPE would be substantively consolidated with the parent s assets in a bankruptcy proceeding involving the parent. [ ] It is important to note that this structure is often very important to the attorneys analysis. The accounting conclusion as to whether the transaction is a sale for financial statement purposes may factor into the attorneys reasoning as to whether the assets have been isolated from a transferor s creditors in the event of transferor bankruptcy, but should not be determinative. Thus, it is acceptable to have a transaction consolidated for accounting purposes, but for the investors to still receive assurance in the form of the lawyers letters that the assets have been sold in a true sale. The FASB thought it important to emphasize that legal isolation must be determined from the perspective of the transferor and all of its consolidated affiliates, excepting those entities that, by design, were remote from the possibility that the particular entity itself would enter bankruptcy. Since most securitizations, as structured currently, may end up consolidated onto the transferor s balance sheet, the FASB wanted to highlight that while the legal analysis with respect to legal isolation may treat bankruptcy-remote entities differently, the accounting analysis with respect to consolidation still needs to be performed for such entities. As stated in : For multiple step transfers, bankruptcy-remote entities 6 are not considered a consolidated affiliate for purposes of performing the isolation analysis. {par. 9a} See Chapter 4 for the discussion of lawyer s letters needed to provide reasonable assurance that the transferred assets would be beyond the reach of creditors. A legal opinion may not be required if a transferor has a reasonable basis to conclude that the appropriate legal opinion(s) would be given if requested. For example, the transferor might reach a conclusion without 6 The exact phrasing that the FASB uses is designed to make remote the possibility that it would enter bankruptcy or other receivership. The judgment should consider all available evidence, including any jurisdictional matters such as whether any resolution case would be governed by the FDIC rules or foreign laws. Chapter 3 19

20 consulting an attorney if (1) the transfer is a routine transfer of financial assets that does not result in any continuing involvement by the transferor or (2) the transferor had experience with other transfers with similar facts and circumstances under the same applicable laws and regulations. [ B] For entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures, judgments about whether transferred financial assets have been isolated need to be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions. Examples include banks subject to receivership by the Federal Deposit Insurance Corporation (FDIC) or insurance companies subject to state regulation. [ B] b. Ability of transferee to pledge or exchange the transferred assets [ (b)] When the transferee is a securitization vehicle that is constrained from pledging or exchanging the transferred assets, each third-party holder of its beneficial interests must have the right to pledge or exchange those beneficial interests. No condition can constrain the holder from taking advantage of its right to pledge or exchange if it provides more than a trivial benefit to the transferor. {par.9b} Any restrictions or constraints on the holder s rights to monetize the cash inflows (the primary economic benefits of financial assets) by pledging or selling those beneficial interests have to be carefully evaluated to determine whether the restriction precludes sale accounting, particularly if the restriction provides more than a trivial benefit to the transferor, which it is presumed to do, unless that can be rebutted by the facts. [ ] For securitizations, the (b) criterion needs to be evaluated with respect to the terms and conditions placed on each third-party holder of the securitization SPE s beneficial interests, since the transaction terms usually constrain the SPE itself from pledging or exchanging the transferred assets. To fail this criterion, the constraint must provide the transferor more than a trivial benefit. Judgment is required to assess whether a particular condition results in a constraint, and also is required to assess whether that constraint provides a more-than-trivial benefit to the transferor. If the transferee is an entity whose sole purpose is to engage in securitization or asset-backed financing activities, that entity may be constrained from pledging or exchanging the transferred financial assets to protect the rights of beneficial interest holders in the financial assets of the entity (b) {par. 9b} requires that the transferor look through the constrained entity to determine whether each thirdparty holder of its beneficial interests has the right to pledge or exchange the beneficial interests that it holds. [ ] Holders of an SPE s securities are sometimes limited in their ability to transfer their interests, due to a requirement that permits transfers only if the transfer is exempt from the requirements of the Securities Act. The primary limitation imposed by Rule 144A of the Securities Act, that a potential secondary purchaser must be a sophisticated investor, does not preclude sale accounting, assuming that a large number of qualified buyers exist. Neither does the absence of an active market for the securities. [ ] c. Surrender effective control [ (c)] The transferor, its consolidated affiliates, or its agents cannot effectively maintain control over the transferred assets or third-party beneficial interests related to those transferred assets either through: 20 Securitization accounting