Accounting for Securitization
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Accounting is a crucial issue in securitization, since one of the prime motivations in securitization is to put assets off the balance sheet. Accounting for securitization is not merely a matter of presentation: it reflects on the cost, and therefore, the very viability of the securitization option. If it results into putting of assets off the balance sheet, a securitization option does not constrain the existing financial resources of the firm, and therefore, is not an alternative to equity; has much lesser costs. If it features as a liability on the balance sheet, it competes with other funding options.
Growth of securitization industry has been destined, to quite some extent, by favourable accounting standards.
What are the main accounting standards on securitization?
Internationally, the most comprehensive accounting standard on securitization is the SFAS 140 from Financial Accounting Standards Board, USA. The UK accounting standards body has issued FRS 5, which is essentially not dedicated to securitization but provides the substance-over-form approach, wherein it also contains provisions on securitization. The International Accounting Standards Committee has issued IAS 32/ IAS 39, again generally on accounting for financial instruments, which also contains sections on securitization.
There are number of other countries which have implemented their own accounting standards, but mostly a replica of IAS 32 or FAS 140.
For example, Canada has adapted its own version of FAS 140 - see here for details: http://www.frascanada.ca/item62001.aspx
What is the crux of these accounting standards?
The essential question in securitization is: whether the transfer of receivables involved in the securitization transaction is a sale, or should the asset be retained on books? If it is a sale, the asset in question will go off the books, the money raised thereby will stay off the books, and the transfer might result into a gain or loss on sale. Thus, removal-of-assets treatment is also normally associated with gain-on-sale treatment.
On the other hand, if the transaction is not treated as a sale, it will be accounted for at par with a financial liability or secured lending.
What is the key determinant of whether sale-of-assets should take place?
While traditionally, accounting standards have been concerned with risk-rewards approach, securitisation accounting standards have adopted a different stand. The risk-reward approach would tell us to treat a purported transfer of assets as a sale if there is a substantial transfer of risks and rewards in the asset. If the assets are transferred, but the risks and rewards of the transferor remain unaffected, then the transaction is not a sale but a financial transaction.
Securitisation accounting is not essentially based on risk/reward approach, but rather the "transfer of control" approach. The standard-setters view a transfer of control as a proxy for transfer of risk or rewards. Transfer of control would mean the assets have gone out of the reach of the transferor, whereby the transferor cannot re-acquire the same, except at market price, and the transferee is free to deal with the assets and make a profit on the assets. The underlying basis is: if I sell my car to you, and you are free to sell it further and make a profit, then I have in fact transferred the reward to you: the reward of making a profit on market prices or enjoying it otherwise, and when there is a transfer of a reward, there is inherently a transfer of risk as well - the risk of not earning the reward.
So, the basic determinant of removal-of-asset accounting is transfer of control.
When do we say a transfer of control has taken place?
FAS 140 lists three criteria for surrender of control: true sale, transfer to a qualifying SPV and absence of a buy-back option with the transferor.
What is a "true sale" here? The same as true sale in law?
The accounting standards require that the assets must have been isolated and put beyond the reach of the transferor, or a creditor, or liquidator in bankruptcy. A true sale in law is necessary to achieve this result. Accounting true sale has an added requirement: there must be no possibility of consolidation of the assets of the transferee with the transferor, thereby revoking the true sale first made. This means there can be no true sale for accounting standards, unless there is true sale in law. For more on true sale in law, see our page here.
There were in April 2001 some questions and answers on the isolation criteria by FASB staff - see a news item here on our site.
Can a sale with recourse, or substantial credit enhancement by the transferor, be regarded as a "true sale"?
Mere recourse is not destructive to a sale in law, but substantial dependance of the transferee on the transferor for payments might reflect an intention of funding. See caselaw cited on our page on true sale.
However, credit enhancements are required as a matter of market practice. The US market has mostly adopted a "two tier structure" to avoid any repercussion on true sale due to credit enhancements.
What is a qualifying SPV?
Clear of the verbosity of the standards, a qualifying SPV is an independent legal entity, independent in the sense that it does its own decision-making ("auto pilot", as they say). And it must be a "special purpose" entity, with limitation on its business, assets that it can hold and the transactions it can enter into. The assets as well as the transactions are related to the business of securitization.
The above is an over-simplification. FAS 140 gives details of what the QSPV do, what derivatives it can enter into, etc.
Is an SPV or qualifying SPV a must?
No. One-to-one transactions might also achieve off-balance sheet treatment, provided the buyer has the ability to sell, pledge or otherwise beneficially exploit the asset.
What is so wrong with the buyback option?
As stated before, to qualify for removal-of-asset, the asset must be transferred without any retained option to buyback with the transferor. The purpose of this condition is clear: a transfer with a buyback option is not surrender of control. Example: I sell my car to you but I have the option to buy it back at a prefixed price, I have not actually surrendered my control, as I have still have a beneficial interest. Retention of an option is retention of benefit. Therefore, transfers with call options with the transferor do not qualify as sales.
How about transfers with put options?
A put option is an obligation to buy back, not an option. The option is with the transferee: and understandably, the transferee will not exercise this option for the benefit of the transferor. Hence, there is no problem with a mere put option. However, an "option as well as obligation", that is, one that is a future contract, will disqualify sale treatment.
How about clean up calls?
Clean up calls are call options with the transferor to clean up the transaction, when its outstanding amount falls to an uneconomic level, typically 10% of the original. Such call options are permitted: they will not lead to financing treatment. See also Martin Rosenblatt's graphic here.
If my transaction is eligible for sale-of-assets, how do I compute the gain-on-sale?
Fairly complicated, and based on a substantial amount of "guesstimates". The working has to do with (a) finding the fair value of assets sold, that is, net of losses or liabilities created by the transaction; (b) estimating the value of retained interests, such as subordinate interests, servicing assets, residuary interest, etc; (c) allocating the carrying amount of the assets as per books to the values in (a) and (b) proportionately.
How about accounting for investors?
Accounting for investors in senior tranches of securitised paper is largely similar to any other debt security, but for junior classes, there is a leveraged impact of credit risk, prepayment or delayed payment risk, etc. The US accounting standards provide guide to investor accounting in EITF 99-20. See Martin Rosenblatt's article on this site here.
What is wrong with Gain on Sale accounting?
The assumption-dependance of the results. The value of the retained interest, recourse liability etc are based on estimates. The critical estimates are the prepayment rates in case of mortgages and the delinquency rates in case of other assets.
There is heavy reliance on estimation. Standard setters contend that there is nothing wrong in accounting valuations based on estimation, as many of the accounting valuations (for example, inventory) is based on estimation. As far as accounting for financial instruments is concerned (IAS 39/ FAS 133), it is almost entirely based on estimation.
However, in practice, there have been several examples of valuation proved to be either wrong, or valuation substantially changing from reporting period to reporting period, leading to chaotic and unpredictable accounting results. See Martin Rosenblatt's article on weaning off gain on sale accounting here on this site.
See a number of news items linked on this site regarding bank failures and regulatory concerns - click here.
What is all the controversy about consolidation of the SPV?
SIC 12 issued by the International Accounting Standards Committee (now IASB) provides for consolidation of SPVs which are quasi-subsidiaries of the originator. A quasi-subsidiary has been interpreted by the IASC to even include entities to which the originator has provided support in form of subordinated securities.
SIC enumerated a 4-point test to provide for https://www.viagrasansordonnancefr.com/viagra-prix/ consolidation of SPVs- (a) the SPE, in substance, is structured in a way that its activities are being conducted on behalf of the enterprise; (b) the enterprise, in substance, has the decision-making powers to obtain control of the SPE or its assets; (c) the enterprise, in substance, has rights to obtain the majority of the benefits of the SPE; or (d) the enterprise, in substance, bears significant residual risks related to the SPE.
The last one is almost inevitably the case in all securitisations.
SIC 12 has been adopted in number of other countries as well. For example, it is TAS No. 44 in Thailand. In Australia, it is UIG 28.
See our recent news item - SIC 12 has been scheduled for revision- click here.
What is the latest on consolidation of the SPEs under US GAAPs?
After Enron's use or misuse of SPEs for hiving off substantial risks off the balance sheet came into light, "special purpose entites" has become a sort of dirty word in public perception. See our page on SPEs. In response, the FASB has come out with a draft of an interpretation that provides for consolidation of SPVs with the primary beneficiary under certain circumstances.
There are three significant exceptions to applying the new exposure draft.
- One, it does not apply to QSPEs covered by FAS 140.
- Two, if it is not an SPE at all
- Three, if it qualifies as an SPE consolidated using voting interests as per normal procedure for consolidations.
Qualifying SPEs (QSPEs) covered by Para 35 of FAS 140 are outside the scope of the new interpretation. FAS 140 allows QSPEs to hold only passive financial assets and passive derivative contracts. Essentially, a QSPE cannot have the ability to exercise discretion on assets and derivatives - it must be an auto-pilot and brain-dead entity. Arbitrage CDO vehicles will certainly not qualify under this requirement. A number of synthetic CDO vehicles also may not qualify, given the fact that a right to claim the assets of the SPE under a credit default swap is treated as a beneficial interest, putting the independence of the SPE from the protection buyer to question.
An entity is not an SPE if it is a "substantive operating enterprise" which necessitates employees, sufficient equity to finance its operations and operative business activities. If an enterprise is not an SPE, obviously, the usual consolidation rules based on ownership, control and management will apply.
Para 9 of the Draft provides for conditions where inspite of the SPE being an SPE, the usual consolidation rules based on voting control will be applicable. Two major conditions here are - sufficient equity, and the equity not being provided by parties with variable interests such as fees, charitable contributions, etc. While sufficiency of equity is judged based on circumstances, lower than 10% of total assets is presumed to be insufficient.
Where equity is insufficient and other conditions of para 9 are not applicable, the SPE will come for consolidation based on holding of "variable interest", which, in essence, is a vague definition of the time-tested concept of equity being a residual economic interest. It would be difficult to come across cases where some one's interest in an enterprise can be treated as "variable interest" but not economic equity. Variable interests are defined as "the means through which financial support is provided to an SPE and through which the providers gain or lose from activities and events that change the values of the SPE’s assets and liabilities."
New FASB Statement 156 on Servicing assets and servicing liabilities
In March 2006, the Financial Accounting standards Board issued a new statement 156 on servicing assets and liabilities. This is an amendment of FAS 140. Apart from making some provisions about servicing assets and liabilities, the Standard also amends FAS 140 in respect of retained interests in securitisation transactions. It appears that the provision is intended to operate in the same manner as amended IAS 39 which refuses to recognise fractional interests in financial assets unless the same are either separately identifiable cashflows or fully proportional interests.
New FASB Statement 166 on Transfers of Financial Assets and FAS 167 on consolidation
In June 2009, FASB brought about significant change in the matter of accounting for securitization transactions by issuing FAS 166 and FAS 167. FAS 166 amends FAS 140 and FAS 167 amends FIN 46R.
The essence of FAS 166 is to make the following significant changes in accounting for securitization transactions, and generically, any transfer of financial assets:
- The components approach is practically out. Under existing FAS 140, financial assets may be seen as composed of "components", meaning threads of assets and rights embedded in a composite financial asset. Under IAS 39, the components approach was specifically rejected by providing that a financial asset may be atomized only where these "atoms" or components are "fully proportionate" share in the asset, or fully proportionate share in separately identifiable cashflows - for example, interest and principal. FAS 166 brings the concept of "fully proportionate share" in the shape of "participating interest" with a similar definition.
- Under FAS 140, off balance sheet treatment might be achieved even if the transferor continues to maintain a "continuing involvement", that is, have residual interests, retained risks, etc in the asset transferred. Under IAS 39 as existing too, such a continuing involvement was permissible. However, an Exposure Draft of changes in IAS 39 issued in March 2009 proposed a change to deny off balance sheet treatment if there was such continuing involvement. The FAS 166 also brings about a similar change. With regard to transfers that do not qualify for derecognition, FAS 166 requires disclosures similar to those in IFRS 7.
- Significantly, while IAS 39 does not insist on true sale as per law for off balance sheet treatment, it seems from the newly added paras 27A and 27B that true sale will still form the basis of off-balance sheet treatment under FAS 140/FAS 166.
- Significantly, currently, the US consolidation rule about SPVs (called VIEs), viz., FIN 46R does not apply to "qualifying special purpose entities" as defined in FAS 140. The concept of qualifying special purpose entities is being deleted, which now means that securitization SPVs will also come for consolidation as per FIN 46.
- FAS 167 amends FIN 46 to change from the quantitative criteria used in consolidation to the principle of majority financial control. New paras 14A to 14G introduce largely subjective criteria to assess whether there is an entity holding such financial control.
Deloitte guidance on FAS 156 is here