Professional Documents
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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.
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.acsbcanada.org/
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.
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.
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.
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.
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.
The above is an over-simplification. FAS 140 gives details of what the QSPV do, what
derivatives it can enter into, etc.
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.
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.
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.
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.
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.
SIC enumerated a 4-point test to provide for 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.
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.
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.
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."
Links Full text of the Exposure Draft on Consolidation of Certain SPEs is available for
download here. Comments due by August 30, 2002
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.
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