Securitization Accounting The Ins and Outs (and some Dos and Donts) of FAS 166, 167, and

Counting ...

Marty Rosenblatt, Jim Mountain, and Ann Kenyon Eighth Edition January 2010

Contents

Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Appendix

What are FAS 166 and 167 and when do they apply? Who has to consolidate the special purpose entity? How do you determine whether a securitization meets the sale criteria? Do I always need to bother my lawyer for an opinion letter? How about some examples? How will taxes affect my transaction? How do you determine gain or loss on a sale? How do I measure and report fair value information? What are some of the investor accounting issues? Can banks get regulatory capital relief through securitization? How do securitizations fare under international accounting standards? So where is the transparency? Regulation AB and a look into the reporting future Solving the securitization puzzles

4 6 18 29 34 43 58 67 72 81 89 102 113 121

ACCOUNTANT GENERALS WARNING: This publication contains information as of January 15, 2010. Certain aspects of this publication may become outdated due to subsequent development of guidance and interpretations.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.

Whats 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 cant 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 Ive 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 2010

3

Chapter 1 Lets start at the beginning: What are FAS 166 and 167 and when do they apply?
Easy. FAS 1661 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, youve 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 companies2
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. [860-10-05-1] 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, 2009-14) and proposing requirements for identification, documentation and disclosure (but not consolidation) of variable interests in variable interest entities (Issue Paper No. 142, 2009-15).

Securitization accounting

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

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, 2009. 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 whats 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.

Securitization accounting

Special purpose entity/variable interest entity whats 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 entitys 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 VIEs 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 entitys status as a variable interest entity, (b) an enterprises power over a variable interest entity, or (c) an enterprises 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. [810-10-15-13A] 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 VIEs 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. [810-10-25-38A] 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 VIEs 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

Consolidation decision process

Do I have:
a variable interesta in the VIE? Yes power to direct activities that most signicantly impact economic performance? Yes an obligation to absorb losses (or right to receive benets) that could potentially be signicant? Yes I am the primary beneciary controlling nancial interest VIE is consolidated by me No No No

VIE is not consolidated by me

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 PBs 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 dont 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. 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 trusts assets?
8 Securitization accounting

 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? When Might a Servicer or Collateral Manager not be the Primary Beneficiary? Situation 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 (810-10-55-37),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 810-1055-37 {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 VIEs expected losses or receive more than an insignificant amount of the VIEs expected residual returns. d. The service arrangement includes only terms, conditions, or amounts that are customarily present in arrangements for similar services negotiated at arms length. e. The total amounts of anticipated fees are insignificant relative to the total amount of the VIEs anticipated economic performance. f. The anticipated fees are expected to absorb an insignificant amount of the variability associated with the VIEs anticipated economic performance.
3

The FASB has issued an Exposure Draft proposing to amend the original source of that guidance, which is 810-10-55-37 {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 entitys evaluation under 810-10-55-37 (c) {par.B22 (c)}. Finalization is expected shortly after this booklet is published.

Chapter 2

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 entitys 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 entitys 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 issuers 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 issuers 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

 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 entitys economic performance. [810-10-20] 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 entitys 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

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

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 810-10-55-37 {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 providers 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 entitys assets. On the other hand, a fee that was considered insignificant under 810-10-55-37s {par. B22s} probability notion might be considered potentially significant under 810-10-25-38As {par. 14A(b)s} possibility notion as discussed below. [810-10-25-38A] FAS 167 does not define economic performance, but it does indicate that an enterprise must assess the VIEs 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 VIEs 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 810-10-25-38A {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 810-10-25-38A {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

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 enterprises 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. [810-10-25-44] 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 VIEs continued existence (e.g., administrative activities in certain resecuritization entities, such as RE-REMICs), may not be expected to significantly affect the VIEs economic performance. In such situations, determination of the primary beneficiary will need to focus on the activities performed and decisions made at the VIEs inception as part of the VIEs design, because in these situations the initial design had the most significant impact on the economic performance of the VIE. 810-10-25-38F {par. 14F} states, in part, that an enterprises 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 VIEs 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

as part of the design would not be determinative or would not result in the identification of a primary beneficiary. [810-10-25-38F] 810-10-25-38G {par. 14G} states, in part: Consideration should be given to situations in which an enterprises 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 entitys 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 entitys inception as part of the design of the entity. [810-10-25-38G] Thus, in situations in which the ongoing activities of a VIE are not expected to significantly affect the entitys 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 entitys interests or those interests do not absorb more than an insignificant amount of the entitys 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 enterprises 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 entitys 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 entitys 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 entitys 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.

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Reconsideration of the primary beneficiary FAS 167 requires that an enterprise continually reconsider its conclusion regarding which interest holder is the VIEs 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 entitys 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 VIEs 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

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 registrants consolidation of VIEs upon adopting FAS 167 on managements report on internal control over financial reporting (ICFR). He noted that the staffs FAQs4 address situations in which registrants could potentially exclude certain VIEs from managements reports on ICFR. However, Mr. Besch stated that registrants will be expected to include VIEs consolidated upon adoption of FAS 167 in managements 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.

Managements 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 2007.

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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 transfer5 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 SPEs 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 transferors 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. [860-10-40-4] 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 [860-10-40-4] 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 transferors 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

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

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 SPEs 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 parents assets in a bankruptcy proceeding involving the parent. [860-10-55-23] 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 transferors 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 transferors 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 860-10-40-5: For multiple step transfers, bankruptcy-remote entities6 are not considered a consolidated affiliate for purposes of performing the isolation analysis. {par. 9a} See Chapter 4 for the discussion of lawyers 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

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.

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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. [860-10-55-18B] 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. [860-10-55-18B] b. Ability of transferee to pledge or exchange the transferred assets [860-10-40-5 (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 holders 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. [860-10-40-16] For securitizations, the 860-10-40-5 (b) criterion needs to be evaluated with respect to the terms and conditions placed on each third-party holder of the securitization SPEs 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. 860-10-40-5 (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. [860-10-40-15] Holders of an SPEs 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. [860-10-55-33] c. Surrender effective control [860-10-40-5 (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

 An agreement that requires the transferor to repurchase the transferred assets before their maturity (in other words, the agreement both entitles and obligates the transferor to repurchase as would, for example, a forward contract or a repo); or The ability to unilaterally cause the SPE to return specific assets, other than through a cleanup call that conveys more than a trivial benefit to the transferor (see discussion on page 23 of cleanup and other types of calls). An agreement that permits the transferee to require the transferor to repurchase the transferred assets that is priced so favorably that it is probable that the transferee will, in fact, require the transferor to repurchase them. {par. 9c} FAS 166 chose to preclude sale accounting if the transferee has any contractual mechanism to require the transferor to take back specific assets on terms that are potentially advantageous through a put option that, when it is written, is deep in the money. In these cases, the transferor maintains effective control since it has priced the transferees option on terms so favorable that it is probable that the transferee will require the transferor to repurchase. If the put option is priced at fair value or, when it is written, is priced sufficiently out of the money so that it is probable that it will not be exercised, then the option would not preclude sales treatment. [860-10-55-42D] What if I fail to comply with the sale criteria? If the securitization does not qualify as a sale, the proceeds (other than beneficial interests in the securitized assets) are accounted for as a liability a secured borrowing. The assets will remain on the balance sheet with no change in measurement meaning that no gain or loss is recognized. [860-30-25-2] With no gain or loss recognized, the assets should be classified separately from other assets that are unencumbered. [860-30-25-2] For more discussion concerning the disclosure requirements for secured borrowings and some illustrative examples, please see Chapter 12, So where is the transparency?. The securities relating to the transferred assets that are legally owned by the transferor or any consolidated affiliate (i.e., the securities that are not issued for proceeds to third parties) do not appear on the transferors consolidated balance sheet. They are economically represented as being the difference between the securitization-related assets and the securitization-related liabilities on the balance sheet. Ongoing accounting for a securitization, even if treated as a financing, requires many subjective judgments and estimates and could still cause volatility in earnings due to the usual factors of prepayments, credit losses, and interest rate movements. After all, the company still effectively owns a residual. Securitizations accounted for as financings are often not that much different economically than securitizations that qualify for sale accounting treatment. Therefore, the excess of the securitized assets (which remain on balance sheet) over the related funding (in the form of recorded securitization debt) is closely analogous economically to a retained residual. Who is considered to be the transferor in a rent-a-shelf transaction? Often times, a commercial or investment bank will rent its SEC shelf registration statement to an unseasoned securitizer who does not have one. The loan originator first sells the loans to a depositor,

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21

which is typically a wholly owned, bankruptcy-remote, special purpose corporation established by the commercial or investment bank. The depositor immediately transfers the loans to a special purpose trust issuer that issues the securities sold to the investors. The loan originator often takes back one or more (usually subordinated) tranches. In this situation, even though the depositor sub of the commercial or investment bank transferred the loans to the trust issuer, it was doing so more as an accommodation to the loan originator and was not taking the typical risk as a principal. If the securitization transaction with outside investors for some reason failed to take place, the depositor would not acquire the loans from the originator. Accordingly, it is the loan originator that would be considered the transferor for purposes of applying the FAS 166 sale criteria to the securitization. FAS 166 emphasizes the role of agent in evaluating transactions. As defined, an agent is a party that acts for and on behalf of another party; thus, in the scenario presented above, the depositor would be viewed to be acting as an agent for purposes of identifying who is the transferor. On the other hand, commercial or investment banks often purchase whole loans from one or more loan originators (sometimes servicing retained) and accumulate those loans to be securitized using the dealers shelf when and how the dealer chooses. In this situation, the commercial or investment bank would be considered the transferor for purposes of applying the FAS 166 sale criteria to the securitization. When trying to determine if an entity is acting as a principal or an agent in a transaction, Emerging Issues Task Force (EITF) Issue Nos. 96-19, Debtors Accounting for a Modification or Exchange of Debt Instruments [470-50-40], and 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent [605-45-45], should be considered. If you dont put it to me, can I call it from you? Lets deal with puts first, because the rules are easier. Its interesting (and to some, counterintuitive) that options allowing investors to put their bonds back to the transferor generally do not preclude sale treatment (but be sure to check with legal counsel, as put options complicate the legal true sale analysis). The FASBs position here is consistent with the theory that the seller has relinquished control

22

Securitization accounting

over the transferred assets; the transferee has obtained control, even if it proves only to be temporary. But a put option that is sufficiently deep-in-the-money when it is written, causing it to be probable that the transferee will exercise it, is problematic. [860-10-55-42D] These puts are viewed as the economic equivalent of a forward contract or repurchase agreement. Put options have been successfully used in transactions in order to create guaranteed final maturities of short-term tranches to achieve liquid asset treatment for thrifts or money market treatment for certain other classes of investors but a number of detailed accounting requirements must be considered. Also, hybrid ARMs have been securitized with a put exercisable at the point when the loans turn from a fixed to an adjustable rate. When a securitization with a put feature is accounted for as a sale, the transferor has to record a liability equal to the fair value of the put obligation. Now for the hard part: Analyzing call options continues to be the area under FAS 166 that probably is the most conceptual, confusing, and prone to misinterpretation. FAS 166 describes several types of calls with each potentially having a different effect on the sale versus financing determination [860-10-40-17(c)]: Attached calls are call options held by the transferor that become part of and are traded with the transferred asset or beneficial interest. Embedded calls are issuer call options held by the maker of a financial asset included in a securitization that is part of and trades with the financial asset. Examples are call options embedded in corporate bonds and prepayment options embedded in mortgage loans. A call might also be embedded in a beneficial interest issued by an SPE. Freestanding calls are calls that are neither embedded in nor attached to an asset subject to that call. For example, a freestanding call may be written by the transferee and held by the transferor of an asset but not travel with the asset. Freestanding calls (other than cleanup calls) are not commonly found in securitization transactions. Conditional calls are call options that the holder does not have the unilateral right to exercise. The right to exercise is conditioned on the occurrence of some event (not merely the passage of time) that is outside the control of the transferor, its affiliates, and agents. Cleanup calls as referenced in FAS 166 are options held by the servicer or its affiliate (which may be the transferor), to purchase the remaining transferred financial assets if the amount of outstanding assets or beneficial interests falls to a level at which the cost of servicing those assets or beneficial interests becomes burdensome in relation to the benefits of servicing. (Some readers think that 10 percent is synonymous with a cleanup call regardless of who holds it and are surprised that neither the amount 10 percent nor any party other than the servicer or its affiliates appears anywhere in the FAS 166s definition of a cleanup call). In-substance call options are deemed to exist when the transferor has the right to cause the transferee to sell the assets and (1) has a right such as a right of first refusal to obtain the assets or (2) has some economic advantage providing it, in-substance, with the practical right to obtain the asset because it is not penalized by paying more than the fair value of the asset. Examples of such advantages are ownership of the residual interest or an arrangement, such as a total return swap with the transferee. Removal of accounts provisions (ROAP): ROAPs permit the transferor to reclaim assets, subject to certain restrictions. In revolving deals, exercise of a ROAP often does not require payment of any consideration, other than reduction of the transferors received interest (the sellers interest). ROAPs are commonly, though not exclusively, used in revolving transactions involving credit cards.
Chapter 3 23

Accounting for default call options

Can transferor (or afliate) repurchase defaulted loans? Yes Has a loan defaulted and triggered the call? Yes Remains unexercised Options status Exercised Record loan as an asset and a liability for the option strike price Keep recorded loan asset and derecognize option liability as paid Derecognize loan asset and options liability No No

No accounting issue

Waived or expired unexercised

Calling all calls? Rights or obligations to reacquire specific transferred assets or beneficial interests, which both constrain the transferee and provide more than a trivial benefit to the transferor, preclude sale accounting. Consider, for example, a transaction where the beneficial interest holders agree to sell their interests back to the transferor at the transferors request for a price equal to the holders initial cost plus a stated return. Any such arrangement would be viewed as providing more than a trivial benefit to the transferor. [860-10-40-15] On the other hand, if the call options strike price was set at fair market value on date of exercise, it is unlikely that the transferor would be viewed as retaining more than a trivial benefit. If the transferor holds a call option to repurchase from the portfolio ANY loans it chooses, then sale accounting is precluded for the transfer of the entire portfolio (even if the option is subject to some specified limit, assuming all loans in the pool are smaller than such limit), because the transferor can unilaterally remove specific assets so control has not been transferred. [860-10-65-3] How conditional must a conditional call be? FAS 166 makes a distinction between call options that are unilaterally exercisable by the transferor and call options for which the exercise by the transferor is conditioned upon an event outside its control. If the conditional event is outside its control, the transferor is not considered to have retained effective control. An example of a conditional call would be a right to repurchase defaulted loans. Another example would be a right to call the remaining beneficial interests subject to a put option, which is exercisable only in the event that holders of at least 75 percent of the securities put their interests. Once the condition is met and if there is more than a trivial benefit to the transferor, the assets under option are to be brought back on balance sheet, regardless of the transferors intent, until the option expires. [860-10-40-4] When the assets under option are brought back on balance sheet, the transferor treats them as if they were newly purchased. [860-20-25-10 through 13]

24

Securitization accounting

The Q&As contained in FAS 166 do not directly provide any guidance regarding the impact on sale accounting of a call option that is conditioned upon an event that is outside the transferors control, but is likely to occur. An extreme example follows: A transferor sells beneficial interests to third parties but retains the right to reacquire those beneficial interests if London InterBank Offered Rate (LIBOR) increases at any time during the life of the beneficial interests. Although the transferor has no control over the future level of LIBOR, it is highly likely that the call will become exercisable sometime during the life of the beneficial interests, perhaps very soon. Thus, most accountants would likely object to sale accounting. [860-10-40-5(c)] In contrast, depending on what level of LIBOR is set as the strike price, the option could be considered a conditional call because there is less certainty about whether the strike price will ever be reached. Separately, these types of options may also impact the views of the lawyers. Chapter 4 explains more about why that is important. And batting cleanup The FASB rejected a recommendation that would have permitted a transferor who is not the servicer to hold the cleanup call. The FASB believes only a servicer is burdened when the amount of outstanding assets falls to a level at which the cost of servicing the assets becomes excessive the defining condition of a cleanup call. Any other party would be motivated by some other economic incentive in exercising a call. The FASB also permits a servicer cleanup call on beneficial interests because the same sort of burdensome costs versus benefits may arise when the beneficial interests fall to a small portion of their original level. [860-10-40-34] It should be noted, however, that the threshold test for this type of cleanup call is still the burden, or cost, to the servicer versus the benefit of keeping the transaction outstanding; presumably, the cost to the servicer in servicing the transaction differs from the costs associated with the servicing of the assets. Can I still hold on to the ROAPs? ROAPs permit the transferor to reclaim assets, subject to certain restrictions. In revolving deals, exercise of a ROAP often does not require payment of any consideration, other than reduction of the sellers interest. As a general rule, a ROAP for random removal of excess assets is permitted if the ROAP is sufficiently limited so that the transferor cannot remove specific assets (e.g., the ROAP is limited to the amount of the transferors interest and to one removal per month). Why are ROAPs used? For a variety of business reasons. A bank might have an affinity relationship with an organization. If the bank securitizes member balances, it might become necessary to remove them from the deal if the bank loses the relationship with the organization. The balances would then be transferred to the credit card originator and then onto the new bank that holds the affinity relationship. What happened to accounting for a transaction as part sale, part financing? In issuing FAS 166, the FASB made it clear that the effective control criteria apply to: transfers of entire financial assets transfers of a group of entire financial assets transfers of participating interests (more on this later) Consequently, unlike in the past, if there is not a transfer of effective control over the entire pool of receivables placed into a securitization transaction, then the entire transaction is accounted for as a financing. By way of contrast, if, in the past, the transferor retained effective control over a portion of the

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pool of transferred (by having a call option, for example, over some of the transferred assets, but not all, or being able to call certain third-party beneficial interests when the principal has been paid down to a specified percentage of the original principal balance), the transaction would have received sale treatment for the portion where the transferor had relinquished effective control over the assets, but financing treatment for the portion subject to the call. Importantly, the FASB has eliminated this potential outcome with the issuance of FAS 166. Additionally, many transferors in the past were able to retain partial interests in transferred assets and still receive sale treatment for the portion of the pool for which they received cash, i.e., a partial sale. Under FAS 166, transferors must transfer a pool in its entirety; they may receive beneficial interests in the transferred assets, but only if the interests are issued by an unconsolidated transferee. The old limitation on sale accounting to the extent that consideration other than beneficial interests in the transferred assets is received in exchange does not appear in FAS 166. Now, those beneficial interests are treated as proceeds, which becomes important in Chapter 7, where gain and loss calculations are described. What about participations? Banks often issue participations in loans that they have originated, and the requirements for the appropriate accounting for those transactions have always looked to the application of the guidance governing transfers of financial assets. In FAS 166, only participating interests, as defined below, are eligible for sale accounting [860-10-40-6A]: a. Pro rata ownership interest: From the date of the transfer, it represents a proportionate (pro rata) ownership interest in an entire financial asset. The percentage interest held by the transferor may vary over time, however. The entire underlying financial asset remains outstanding as long as the resulting portions held by the transferor and the transferee(s) meet the other characteristics of a participating interest. [860-10-40-6A(a)]

26

Securitization accounting

For example, if the transferors interest in an entire financial asset changes because it subsequently sells another interest in the entire financial asset, the interest held initially and subsequently by the transferor must meet the definition of a participating interest. b. Proportionate division of cash flows: From the date of the transfer, all cash flows including both principal and interest received from the underlying financial asset are divided proportionately among the participating interest holders in an amount equal to their share of ownership. Compensation for services performed, such as servicing, shall not be included in this determination, provided those cash flows are not subordinate to the proportionate cash flows of the participating interest and are not significantly above an amount that would be considered market rate. These fees should include the profit that would be demanded in the marketplace. Any cash flows received by the transferor as proceeds of the transfer of the participating interest shall be excluded from the determination of proportionate cash flows, provided that the transfer does not result in the transferor receiving an ownership interest in the financial asset that permits it to receive disproportionate cash flows. [860-10-40-6A(b)] c. No subordination: The rights of each participating interest holder, including the transferor in its role as a participating interest holder, have the same priority, and no one interest holders interest is subordinated to anothers. That priority may not change in the event of bankruptcy or other receivership of the transferor, the original debtor, or any other participating interest holder. Participating interest holders may have no recourse to the transferor (or its consolidated affiliates or its agents) or to each other, other than standard representations and warranties, ongoing contractual obligations to service the entire financial asset and administer the transfer contract, and contractual obligations to share in any set-off benefits received by any participating interest holder. No participating interest holder is entitled to receive cash before any other participating interest holder under its contractual rights as a participating interest holder. [860-10-40-6A(c)] d. Disposition of the underlying asset: No party has the right to pledge or exchange the underlying financial asset unless all participating interest holders agree to pledge or exchange the underlying financial asset. [860-10-40-6A(d)] If the transferor transfers an entire financial asset in portions that do not individually meet the participating interest definition, sale accounting criteria shall be applied to the entire financial asset once all portions have been transferred. [860-10-40-4B] Many securitizations of trade receivables traditionally relied on a structure in which the transferor transferred a pool of receivables to a bankruptcyremote entity, which then issued a senior undivided beneficial interest in the pool to a multiseller commercial paper conduit. The bankruptcy-remote entity is part of the transferors consolidated group. Consequently, using the criteria set forth above, the undivided beneficial interest issued in the pool to the conduit needs to be evaluated to see if it meets the definition of a participating interest. Since the interest is senior, providing the conduit with necessary levels of credit enhancement in the transaction, the undivided beneficial interest would not meet the definition of a participating interest. Since FAS 166 mandates that transfers of entire assets, an entire pool of assets, or participating interests only can be subjected to the sale criteria in 860-10-40-5 {par. 9}, sellers of trade receivables using this structure would
Chapter 3 27

be precluded from accounting for their transactions as sales. One alternative would be to sell the entire pool of assets in exchange for the same amount of cash and some sort of IOU from the conduit. That transaction is discussed on page 39. What is an entire financial asset? The emphasis in FAS 166 that the requirements for sale accounting must be applied only to a financial asset in its entirety, a pool of financial assets in its entirety, or participating interests highlights the FASBs sentiment that, inherent in this concept, a financial asset (or pool of assets) may not be divided into components prior to transfer unless all of the components meet the definition of a participating interest. What, then, is an entire financial asset what is the unit of account? Here are some examples: A loan to one borrower in accordance with a single contract that is transferred to a securitization entity. Similarly, a beneficial interest in securitized financial assets arising from securitization accounted for as a sale shall be considered an entire financial asset. In a transaction in which the transferor creates an interest-only strip (IO strip) from a loan and then transfers the IO strip, the IO strip does not meet the definition of an entire financial asset. In contrast, if an entire financial asset is transferred to a securitization entity that it does not consolidate and the transfer meets the conditions for sale accounting, the transferor may obtain an IO strip as proceeds from the sale. An IO strip received as proceeds of a sale is an entire financial asset for purposes of evaluating any future transfers that could then be eligible for sale accounting. Also: if multiple advances are made to one borrower in accordance with a single contract (such as a line of credit, credit card loan, or a construction loan), an advance on that contract would be a separate financial asset if the advance retains its identity, does not become part of a larger loan balance, and is transferred in its entirety. if, however, the advances lose their separate identity as part of a larger loan balance, then a participating interest in that larger balance may be eligible for sale accounting. [860-10-55-17E through 17H] Overall, the legal form of the asset and what the asset conveys to its holders are the principal considerations in determining what constitutes an entire asset.

28

Securitization accounting

Chapter 4 Do I always need to bother my lawyer for an opinion letter?

Hopefully, they wont consider it a bother. A true sale opinion from an attorney is often required to support the conclusion that transferred financial assets are isolated from the transferor, its consolidated affiliates, and its creditors. In addition, a non-consolidation opinion is often required if the transfer is to an affiliated entity. In the context of U.S. bankruptcy laws: a. A true sale opinion is an attorneys conclusion that the transferred financial assets have been sold and are beyond the reach of the transferors creditors and that a court would conclude that the transferred financial assets would not be included in the transferors bankruptcy estate. b. A non-consolidation opinion is an attorneys conclusion that a court would recognize that an entity holding the transferred financial assets exists separately from the transferor. Additionally, a non-consolidation opinion is an attorneys conclusion that a court would not order the substantive consolidation of the assets and liabilities of the entity holding the transferred financial assets and the assets and liabilities of the transferor (and its consolidated affiliates included in the financial statements being presented) in the event of the transferors bankruptcy or receivership. It is important to note that bankruptcy non-consolidation is not the same as non-consolidation for GAAP accounting. For entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures (for example, banks subject to receivership by the FDIC or insurance companies subject to state regulation) in the United States or other jurisdictions, 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. At the time of this writing, the AICPA has initiated plans to update its guidance on lawyers letters. In the meantime, the current auditing interpretation called The Use of Legal Interpretations as Evidential Matter to Support Managements Assertion That a Transfer of Financial Assets Has Met the Isolation Criteria in Paragraph 9 (a) of Statement of Financial Accounting Standards No.140 [AICPA AU9336.01-.21] is still in effect. In order for an auditor to be satisfied that legal isolation has occurred in connection with a transfer of assets, lawyers must conclude (1) that a true sale of the assets has occurred (as opposed to merely a secured lending) and (2) the assets of the transferee would not be substantively consolidated with the assets of the transferor in a bankruptcy proceeding involving the transferor. The opinions are generally referred to as true sale and non-consolidation opinions. The AICPA interpretation contains extracts of legal opinions, which provide persuasive evidence (in the absence of contradictory evidence) to support managements assertion that the transferred assets have been isolated. For an entity that is subject to the U.S. Bankruptcy Code, a would opinion, not a should or more likely than not opinion must be obtained. This represents the highest level of assurance counsel is able to provide on the question of isolation. The example follows: We believe [or it is our opinion] that in a properly presented and argued case, as a legal matter, in the event the Seller were to become a Debtor, the transfer of the Financial Assets
Chapter 4 29

from the Seller to the Purchaser would be considered to be a sale [or a true sale] of the Financial Assets from the Seller to the Purchaser and not a loan and, accordingly, the Financial Assets and the proceeds thereof transferred to the Purchaser by the Seller in accordance with the Purchase Agreement would not be deemed to be property of the Sellers estate for purposes of [the relevant sections] of the U.S. Bankruptcy Code. Based upon the assumptions of fact and the discussion set forth above, and on a reasoned analysis of analogous case law, we are of the opinion that in a properly presented and argued case, as a legal matter, in a proceeding under the U.S. Bankruptcy Code, in which the Seller is a Debtor, a court would not grant an order consolidating the assets and liabilities of the Purchaser with those of the Seller in a case involving the insolvency of the Seller under the doctrine of substantive consolidation. If an affiliate of the transferor also participates in some way in the overall transaction, the opinion should address the effect of that involvement on the opinion. An auditor is not required to obtain a legal opinion with respect to the second or any subsequent transfers in a two-step (or more than two-step) securitization provided that (1) the first step achieves isolation as evidenced by the satisfactory legal opinion and (2) each entity that receives either transferred assets or beneficial interests therein in the series of transfers is either (a) not affiliated with the transferor or (b) a bankruptcy-remote special purpose entity included in the same set of consolidated financial statements as the transferor. Where the second transfer or a subsequent transfer is made to a consolidated affiliate of the transferor that is not a bankruptcyremote special purpose entity (e.g., an operating company), the legal opinions should extend to such transfers. Although not required by the auditing interpretation, the lawyer may also be providing an opinion on the second step of a two-step structure involving a bankruptcy-remote SPE, if requested by his client or the rating agencies. The auditor need not be alarmed if the opinion on the second step says something to the effect that such transfer would either be a sale or a grant of a perfected security interest.

30

Securitization accounting

Other issues covered in the auditing interpretation on lawyers letters are addressed below: Questions Key Points

What should the auditor consider Use of a lawyer may not be necessary when there is a routine in determining whether to use transfer of financial assets without continuing involvement by a lawyer to obtain persuasive the transferor (no servicing responsibilities, no participation evidence to support managements in future cash flows, and no recourse obligations other than assertion that a transfer of assets standard reps and warranties). meets the isolation criterion? Use of a lawyer usually is necessary if, in the auditors judgment, the transfer involves complex legal structures, continuing seller involvement, or other legal issues that make it difficult to determine whether the isolation criterion is met. The auditor should evaluate the need for updates to a legal opinion if transfers occur over an extended period of time or if management asserts that a new transaction is the same as a prior structure. The auditor should consider whether the lawyer has experience If the auditor determines that the with relevant matters, such as knowledge of the U.S. Bankruptcy use of a lawyer is required, what Code and other applicable foreign or domestic laws and should the auditor consider in knowledge of the transaction. The lawyer may be a clients assessing the adequacy of the legal internal or external attorney who is knowledgeable about opinion? relevant sections of the law. A lawyers conclusion about hypothetical transactions generally would not provide persuasive evidence because it may be neither relevant to the actual transaction nor contemplate all of the facts and circumstances or the provisions in the agreements of the actual transaction. The auditor should obtain an understanding of the assumptions that are used by the lawyer, and make appropriate tests of any information that management provides to the lawyer and upon which the lawyer indicates he relied. Are legal opinions that restrict the The auditor should request that the client obtain the lawyers written permission for the auditor to use the opinion. Language use of the opinion to the client to the effect that the auditors are authorized to use, but not or to third parties other than the auditor acceptable audit evidence? rely on the lawyers letter is not acceptable audit evidence. The AICPA interpretation has example language that should be acceptable to both auditors and lawyers. Because isolation is assessed primarily from a legal perspective, If the auditor determines that it the auditor usually will not be able to obtain persuasive is appropriate to use the work of evidence in a form other than a legal opinion. In the absence a lawyer, and either the resulting of persuasive evidence, accounting for the transfer as a sale legal response does not provide would not be in conformity with GAAP or the auditors scope persuasive evidence ... or the lawyer has been restricted, and the auditor should consider the need does not grant permission for the to modify the auditors report on the financial statements. auditor to use a legal opinion that is restricted what other steps might an auditor consider?

Chapter 4

31

The auditor also needs to consider the effect of any unusual limitations or disclaimers that might be expressed in the legal opinion in assessing whether the legal letter is adequate audit evidence. For example, the limitation highlighted below is troublesome because it essentially negates an otherwise satisfactory opinion by instructing the reader to perform additional legal analysis of the factors mentioned, thereby implying that those factors have not been considered by the lawyers in forming their opinion: We note that legal opinions on bankruptcy law matters unavoidably have inherent limitations that generally do not exist in respect of other legal issues on which opinions to third parties are typically given. These inherent limitations exist primarily because of the pervasive powers of bankruptcy courts, the overriding goal of reorganization to which other legal rights and policies may be subordinated, the potential relevance to the exercise of judicial discretion of future-arising facts and circumstances, and the nature of the bankruptcy process. The recipients of this opinion should take these limitations into account in analyzing the bankruptcy risks associated with the transactions as contemplated by the Agreements. (Emphasis added.) A sentence, however, that simply told the reader that they should be mindful of these limitations as opposed to suggesting that the reader is being instructed to perform additional analysis of the bankruptcy risks beyond the legal opinion is not troublesome. Do banks have to isolate their assets in a two-step structure to get sale treatment? In August 2000, the FDIC issued a rule designed to help banks meet the legal isolation requirement for GAAP sale treatment. The rule states: The FDIC shall not, by exercise of its authority to disaffirm or repudiate contracts , reclaim, recover, or recharacterize as property of the institution or the receivership any financial assets transferred by an insured depository institution in connection with a securitization [issued by a special purpose entity demonstrably distinct from the insured depository institution] , provided that such transfer meets all conditions for sale accounting under generally accepted accounting treatment, other than the legal isolation condition as it applies to institutions for which the FDIC may be appointed conservator or receiver. ... [12 CFR 360.6] In November, 2009, the FDIC adopted an interim rule amending the regulations defining safe harbor protections for treatment by the FDIC as conservator or receiver of financial assets transferred by an FDIC-insured depository institution in connection with a securitization or participation. The interim rule continues, for a limited time, the safe harbor provision for participations or securitizations that would be affected by FAS 166 and 167. The interim rule also clarifies that safe harbor protections will apply to assets transferred in previously qualifying securitization and participation transactions that close on or before March 31, 2010. The interim rule grandfathers all participations and securitizations for which financial assets were transferred or, for revolving securitization trusts, for which securities were issued prior to March 31, 2010, so long as those participations or securitizations complied with the preexisting provisions under GAAP in effect prior to November 15, 2009. The transitional safe harbor will apply irrespective of whether or not the participation or securitization satisfies all of the current conditions for sale accounting treatment.

32

Securitization accounting

The interim rule alleviates the current investors concerns related to repudiation risk by amending the FDICs securitization rule to extend to transactions that would not qualify as sales under FAS 166 as long as they qualified under FAS 140. The interim rule, along with the related memo from the FDIC general counsel and director of the Division of Resolutions and Receiverships, also address the risk related to stay powers that the FDIC would possess as the receiver in an FDIC-insured bank insolvency by grandfathering pre-FAS 166 and 167 compliant transactions. This new clarity should afford the support necessary for reliance by opining law firms providing the legal opinions on bank-sponsored transactions closed on or before March 31, 2010, of a certainty consistent with highly rated asset-backed transactions, potentially possessing credit ratings higher than that of the sponsoring institution. There is a reasonable likelihood that this interim rule will be extended beyond March 31, 2010, while the FDIC and the other banking agencies consider other requirements they believe should be placed on bank-sponsored securitizations. Are there special legal opinions for banks and thrifts? If the transferor is not subject to the U.S. Bankruptcy Code, but is subject to receivership or conservatorship under provisions of the Federal Deposit Insurance Act, there are two alternate forms of legal opinions that would be acceptable. A lawyer might choose to give a true sale opinion or the lawyer might choose to give an opinion addressing isolation both prior to the appointment of the FDIC as a receiver and following the appointment of the FDIC as receiver. As the FDIC deliberates the effect of FAS 166 on its safe harbor for securitizations, it is likely that attorneys opinions addressing the legal isolation in the event that the FDIC were appointed receiver will also change. Nevertheless, regardless of which form of true sale opinion is rendered, the attorneys should still address the doctrine of substantive consolidation as discussed above.

Chapter 4

33

Chapter 5 How about some examples?

My asset class is: Private label MBS the traditional two stepper Private label residential mortgage securitizations would typically have the structure shown below: Notwithstanding all the boxes, we would refer to this structure as the prototype two-step securitization transaction, as described in Chapter 3. The sponsor, who may or may not be the originator, forms the pool of loans and transfers them to the depositor, which is a bankruptcy-remote special purpose entity. The depositor, which traditionally has been consolidated with the transferor/sponsor for accounting purposes, in turn transfers the pool to the issuer, who issues the bond classes back to the depositor, who in turn surrenders them to the underwriter to be sold to investors. Since 1997, it is the issuer that was typically designed to meet the definition of a QSPE and thus had not been consolidated; since the issuer has the assets (mortgage loans) and debt (bonds or certificates), the effect had been to derecognize the transferred assets from the balance sheet of the transferor.

loan origination

Mortgagors

loan payments Servicer (services mortgage pool)

Originator(s) sell loans loan purchase price

amount nanced

Sponsor (purchases loans, forms pool) asset pool net offering proceeds net offering proceeds certicates Trustee and Custodian (represents investor interests, calculates cashows, remits to investors, holds mortgage loans) monthly distributions Investors Underwriter (sells certicates to investors) certicates gross offering proceeds monthly distributions

Depositor (creates issuing entity) asset pool certicates

Issuing Entity (holds pool, issues certicates)

34

Securitization accounting

What roles does the originator play besides origination? What is the impact if originator is the servicer? What happens if the originator holds bottom classes or if the originator holds bottom classes and is the servicer? The accounting analysis under FAS 166 and, especially, FAS 167, is likely to result in a far different accounting conclusion than had previously been the case. Clearly, the transferor/sponsor is intimately involved in the design of the transaction; indeed, it is likely that one of the primary purposes of this transaction is to facilitate the liquidity needs of the transferor. Thus, it is important to identify which of the parties have a variable interest in the deal that would potentially expose them to the obligation to absorb losses or to receive benefits that could be significant to the issuer, what are the activities that would most significantly impact the economic performance of the issuer, and who is in control of those activities. Most often, the transferor/sponsor retains the servicing function, for which it receives a fee. Since the transferor/sponsor generally also retains an interest in the residual tranche of the issuer (as well as possibly one or more of the subordinate classes), the servicing fee might be considered a variable interest that could absorb potentially significant losses or receive potentially significant benefits. As elaborated in the basis for conclusions in FAS 167, the FASB considers a servicer who has only a fee that meets the 810-1055-37 {par.B22} tests (and therefore does not have a variable interest) to be acting only in a fiduciary capacity; a servicer who receives a servicing fee and is exposed to the expected losses of the SPE, such as through an interest in a residual tranche, to be acting far more as a principal in the transaction, and could likely be deemed the primary beneficiary. With respect to activities that would impact the economic performance of the issuer most significantly, many accountants would argue that the default management function has the most significant impact on the economic activities of the trust. In RMBS, the servicer has the ability to work with the obligor in granting loan workouts or forbearance. The servicer also would generally be responsible for selling the underlying property should the obligor default and the real estate become the property of the issuer trust via foreclosure. That variable interest could potentially absorb the losses of the issuer. Because the transferors/sponsors of private label RMBS would generally meet both tests, it would be deemed the primary beneficiary of the issuer trust, and thus the consolidator of the trust. Accordingly, the balance sheet of the transferor/sponsor looks very different after it adopts FAS 166 and 167; unlike in the past, it will keep the mortgage loans and issued bond classes on its books, thus grossing up both sides of the balance sheet and precluding gain on sale or establishment of a servicing asset. What would happen if there are multiple originators with each originator acting as a servicer for the assets it transferred, with a master servicer in place for the entire pool? Assuming that transferors assets represented no more than 50 percent of the pool [810-10-25-55] and that the cash flows from the assets are available to satisfy the transactions liabilities (i.e., there are no silos) [810-10-25-57], and the master servicer does not have kick out rights over the primary servicers, this would be an example where the very possible conclusion is that no one might be deemed the primary beneficiary. The role of the master servicer should be closely evaluated.

Chapter 5

35

Credit cards aka revolving master trusts

Bank

Receivables

Depositor SPV

Receivables Purchase Agreements

Receivables

Transferor Interest

Transfer and Servicing Agreement Indenture Series 2009-1 Indenture Supplement

Issuance Trust (Issuing Entity)

Series 2009-1

Noteholders

Credit card securitizations have some very different considerations from RMBS. Unlike mortgage securitizations, in which a static pool of long-term loans is placed into a structure, credit cards are assets whose maturities are substantially shorter than a mortgage loan. Often a pool of credit card receivables will turn over in a period measured in months. Since the tenor of the receivables is much shorter than the life of the issued bonds, credit card securitizations are called revolving securitizations; the transferor may, for some extended period of time, receive collections from the issuer trust as proceeds for the purchase of new receivables, thus replacing those that have been entirely collected. During this revolving period, bond holders receive interest on their holdings, but not principal. At a time defined in the transaction documents, the revolving period will end and principal collections will accumulate in an account held in the issuer trust; this is called the accumulation period. Finally, when it is time for the deal to unwind, collections that have been accumulated are used to pay the bondholders during a period that is called the amortization period. Triggers are built into these structures, and if some adverse event happens, the revolving period stops early and the deal starts to unwind. This is called an early amortization event. Idiosyncratic to credit card securitizations, the transferor, which is the bank that issued the credit cards and has the receivables, will often transfer them directly into a master trust, which is a bankruptcy-remote vehicle designed to issue different series of bonds at different intervals. There have been questions throughout the years as to whether the issuance of series of bonds should be viewed as silos, or whether it is the trust as whole that needs to be evaluated for consolidation. The old QSPE guidance was not so clear on this point; 810-10-25-57 {par.13} makes reference to silos whereby the cash flows of specified assets and related credit enhancements are contractually the only source of repayment for designated liabilities. Issuers of credit card securitizations should look to the degree of cross collateralization, if any,

36

Securitization accounting

that exists among the series in order to determine if the master trust essentially represents a single VIE, or a VIE that is composed of a series of silos or individual VIEs. Currently, since most credit card securitizers retain servicing as well as the account relationship with the customers, and have variable interests in the master trust through its sellers interest, interests in cash collateral accounts, IO strip and servicing fee, the credit card bank would be identified as the primary beneficiary. Trade receivables and asset-backed commercial paper conduits not your typical securitization Most commonly, when people think about securitization, there is a tendency to think that the transferred assets are interest bearing and that the sponsor of the securitization will establish a trust or use some other vehicle to issue securities directly into the markets. Well, not all financial assets are interest bearing, and not all securitizations are term transactions sold directly into the capital markets.
Arranger bank Partial credit enhancement Liquidity line Assets CP Conduit CP periodic payments Purchase price for CP Purchase price for assets Seller Originator Purchase price for assets

Assets

Investors

Sellers of trade receivables, issuers of very senior tranches of credit card and auto loan securitizations, and transferors of asset classes that are considered to be exotic asset classes (lottery receivables, life settlements, etc.) are all users of asset-backed commercial paper conduits. While some would contend that CP conduits were established primarily to facilitate securitizing assets with a short tenor, such as trade receivables, they now have expanded to include most asset types. As a result of the turmoil in the financial markets, though many conduits may be rethinking this strategy. By matching the liquidity and duration of the commercial paper to the underlying receivables, CP conduits greatly enhanced the access of Main Street companies and nontraditional securitizers to the capital markets. These CP conduit deals also allow securitizers to maintain a level of confidentiality regarding their customer base. In this fashion, CP conduits allow companies to: securitize their trade receivables in smaller transaction sizes pay lower transaction costs often get better execution for the funding, even if their names are not familiar to the marketplace learn about the nuances of securitization and the consequent reporting in the process

Chapter 5

37

What is the analysis from the sellers perspective? A typical seller of trade or other receivables will transfer the financial assets to a bankruptcy-remote specialpurpose entity. In recent years, these special purpose entities issued senior interests in the receivable pools to the CP conduit, which then issued the commercial paper. The proceeds of the issuance are forwarded to the sellers SPE from the conduit, and that is the cash which that SPE uses to purchase the receivables from the transferor. Most CP conduits protect themselves from credit defaults in the underlying receivables by requiring a fair degree of overcollateralization by purchasing the senior interest in the pool of receivables. Advance rates vary over a large range. This means that the SPE needs to get an additional financing for its receivables purchase from its parent either in the form of a note or a capital contribution. Looking at this from the perspective of a seller of receivables to the conduit, the SPE established by the transferor and discussed above is consolidated with the seller, since the seller has a variable interest in the entity through its interest in the overcollateralization, and certainly exhibits control of its activities through retention of servicing. In essence, since the seller has not sold an asset or a pool of assets in its entirety (but rather issued an interest in the pool), the considerations around participating interests now come into play. Since these transactions are structured to leave the sellers in a first loss position, such subordination runs counter to the requirement that all holders of interests in the pool must have the same priority. We have seen proposed transactions whereby the conduits may rely on structures that we have not seen since the early days of securitization. Consistent with the FAS 166 concept that an entire pool of receivables may be sold in its entirety, some conduit sponsors may begin purchasing the entire asset pool, and the purchase price paid to the seller would be settled in a combination of cash and a deferred purchase price note issued by the conduit. What if the seller transfers the entire pool to the conduit? If the seller transfers the entire pool to the conduit, then the transaction must also conform to the requirements in 860-10-40-5 {par.9}. With respect to legal isolation, both the true sale and non-consolidation opinions traditional to term securitizations are needed.

38

Securitization accounting

As is traditionally the case, the legal documents serve as the basis for determining if control over the receivables has been ceded. One common area of trouble that will result in a transaction not achieving sale treatment is a seemingly benign feature that allows the SPE to prepay the conduit at any time. The SPE should have only three sources of cash: (1) proceeds from the conduits issuance of commercial paper, (2) collections, and (3) cash coming from the transferor. In the prepayment scenario, it would make no sense for the conduit to issue more commercial paper in order for the SPE to use the proceeds to pay off existing commercial paper this trade would leave the SPE and the conduit in the same position. Using cash from collections is a perfectly logical thing for the SPE to do; after all, having the receivables liquidate and using the collections to pay the investor is inherent in any securitization. It is when the transferor has the ability to infuse the SPE with cash in order for it to make the prepayment does the analysis get complicated. This may be viewed as effective control, since the transferor would have the ability to get the receivables back in exchange for its cash. What about the conduit? How does that work? Commercial paper conduits, typically sponsored by commercial banks, historically have been grouped into three categories: securities arbitrage vehicles, multiseller vehicles, or loan-backed vehicles. Loan-backed conduits purchased loans either from the sponsoring bank or from another institution; securities arbitrage vehicles worked similarly, instead just buying debt- and asset-backed securities. While all programs were originally seen in the marketplace, currently it is the multiseller conduits that are the biggest and most active players. The sponsoring commercial bank plays some traditional roles with respect to a multiseller conduit. The bank generally markets the transactions with the sellers of the receivables, and is actively involved in the deals structuring. Additionally, the bank usually acts as the administrator of the conduit, for which it receives a fee. Finally, the bank generally also extends credit enhancement and liquidity facilities to the conduit, although some of that exposure may be syndicated out to other banks. Thus, from the banks perspective, it is an active participant in directing the economic activities of the conduit: it finds the deals, structures the transactions, and often administers the conduit. It has variable interests to the conduit in the form of the extended credit and liquidity lines, as well as the fees that it receives from administration. Through those variable interests, they have the obligation to absorb losses and to receive benefits from the vehicle. Consequently, as a result of the adoption of FAS 167, most commercial banks stand ready to consolidate (albeit not happily) the conduits that they sponsor. What happens if the liquidity facility is shared among several arrangers? What happens if the conduit has multiple parties managing different activities (asset management versus funding)? As mentioned above, banks often try to have other banks participate in extending liquidity to their conduits. (In turn, the same bank may reciprocate and participate in extending liquidity to another banks conduit). While this certainly reduces one banks exposure to problems in the conduit, the liquidity lines are there to support the issuance and rolling over of the commercial paper, a short-term instrument. Thus, while it is an important fact to consider in the consolidation analysis, one must consider all the interests the bank has to the conduit in order to appropriately conclude if the bank is the primary beneficiary; as discussed above, it is the combination of those variable interests with the control over the most significant economic activities of the conduit that places the sponsor bank as the likely primary beneficiary.
Chapter 5 39

Commercial mortgage securitization where the transferor may not be the primary beneficiary
P&I Collections (less servicing fee and other expenses)

Trustee

Master servicer

Trustee

REMIC Trust Mortgage loan seller/servicer Mortgage loan seller/servicer Mortgage loan seller/servicer Individual mortgage loans AAA rated class P&I Collections AA rated class A rated class BBB rated class Defaults Workouts Liquidations BB rated class B rated class Unrated class Directing certicate holder Indenture Trustee Owner Trustee Subordinate interests Operating advisor

Individual mortgage loans

Individual mortgage loans

Special servicer

Losses

Like their RMBS cousins, commercial mortgage backed securitizations generally have the same parties present in the transaction: the transferor of the loans, the servicer, trustee and underwriters, and the issuer of the notes, which is typically set up as a REMIC trust. However, given the complexities of working out troubled commercial mortgages and managing the underlying properties, these transactions also include a special servicer should the obligor default. Typically, commercial mortgage loan securitizations involve mortgages with individually large principal balances. If the borrower or property encounters financial or operational difficulties, experienced workout specialists are needed to maximize ongoing cash flows from the loan or to prevent further deterioration in value. When commercial mortgage loans are securitized, a special servicer with the relevant expertise and experience is hired to take over from the servicer and perform these functions with respect to each loan that becomes a troubled loan. The special servicer may acquire a subordinated beneficial interests and often has a right to call defaulted loans. Sometimes, the special servicer is the same entity as the primary servicer. When a loan is assigned to the special servicer, there is a range of responses available. Absent any external constraints, the possible responses fall into the following general categories: the special servicer on behalf of the trust could (1) modify the terms of the existing loan, (2) commence foreclosure
40 Securitization accounting

proceedings; or (3) sell the loan for cash (either in the markets or in response to a call by the special servicer or a subordinated interest holder). Thus, in evaluating who is in control of the activities that have the most significant impact on the trusts economic performance, it is difficult to avoid the conclusion that the special servicer fits that role subject to the discussion below on kickout rights. What happens if the special servicer is not a mortgage loan seller but buys the subordinate bonds? What happens if the special servicer does not hold the subordinate bonds? In CMBS, the special servicer is typically not the transferor of the mortgages. Additionally, they may, but not always, also hold a subordinate class of bonds; the special servicing fee also may vary with the economic results of the trust, thus incentivizing the special servicer to maximize loan performance. Holding a subordinate position in the transaction, in combination with the default management required in the role of special servicer (and absent any kickout rights held by a single noteholder), would lead to the conclusion that the special servicer would be the primary beneficiary, even if they were not the transferor. CMBS transactions also generally have the concept of a controlling classholder, and this controlling classholder often may have the discretion to remove the special servicer. Often, the special servicer may hold the class of bonds which also makes them the controlling classholder, but typically the transaction documents provide for the circumstance where losses erode the controlling classholders interest, and thus the next more senior class of noteholders would become the controlling class. In a scenario such as this, the continual assessment requirement in FAS 167 may result in the identification of a new party becoming the primary beneficiary, assuming the rights were held by one party. CDOs and CLOs whats an asset manager to do? Collateralized debt obligations and collateralized loan obligations may have a structure that looks like this:
Trustee (protects investors security interest in the collateral and performs other duties)

Asset Manager (manages Issuers assets makes investment decisions) Investors Class A notes Class B notes Class C notes Class D notes Class E notes Equity Periodic payments Purchase price

Issuer SPE (buys debt and issues ABS using the debt as collateral) Swap agreement

Portfolio of debt Seller(s) of Debt Purchase price for portfolio

Swap Counterparty (provides interest rate swap, cash ow swap, etc.)

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As we have seen with the securitization structures established for different asset types, this arrangement has many of the same features: assets, in some cases the issued notes from other securitizations, are purchased by an issuer entity. This entity issues notes into the capital markets and the trustee is charged with protecting the noteholders interest. Often, a financial institution will enter into a derivative with the issuer trust, such as an interest rate or cash flow swap, that will serve to protect the noteholders from some fundamental mismatch of a basic money term (e.g., there is index risk if the underlying assets earn interest based on a floating rate linked to the prime rate, for example, but the issuer trusts noteholders earn interest based on a floating rate linked to LIBOR). All of these parties may be found present in other securitizations. The asset manager performs different functions for a CDO/CLO than a servicer does for a more generic securitization. Here, the asset manager is charged with managing the composition of the issuers collateral such that specific measures and concentrations of assets are in compliance with the transaction documents. Consequently, the asset manager determines which assets need to be replaced in a transaction for credit or other reasons and, in many cases, determines which assets may be purchased to add to the issuers portfolio when reinvesting principal collections. Will the asset manager be considered the primary beneficiary of the CDO/CLO? Assume that an asset manager creates a CDO and retains 20 percent of the unrated equity securities. The senior and mezzanine securities are distributed to several investors. The equity class provides credit support to the higher tranches and was sized to absorb a majority (but not all) of the expected losses of the CDO. The asset manager will need to include the effects of its right to receive benefits or obligation to absorb losses that could potentially be significant to the issuer trust of its management fees because the collateral manager is a decision maker for the CDO. The collateral manager is not simply a service provider because it also holds another significant variable interest in the form of 20 percent of the equity class. As we have seen, the asset manager is the entity that has the power to direct activities that most significantly impact the issuer trusts economic performance. Through its ability to determine which assets must be sold, and often in its ability to choose which assets will be purchased, the asset manager is in a unique position to direct the activities that most significantly impact the economic activities of the issuer trust. It would be the primary beneficiary and would need to consolidate the CDO. Lastly, special care should be paid in determining the primary beneficiary when the asset manager of a CLO receives fees that are more consistent with the service provider model. This might be the case for static deals with only senior fees. Also, because of FAS 167s continual reconsideration framework, situations might evolve over a deals life that result in senior fee streams as the sole remaining substantive income to be earned by the asset manager, thus triggering greater scrutiny of the primary beneficiary determination.

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Securitization accounting

Chapter 6 How will taxes affect my transaction?

Sometimes a blessing, sometimes not; the current U.S. income tax rules7 (tax rules) for securitization transactions can be quite different from the applicable GAAP rules. Perhaps the most significant implication of these differences stems from their effect on the overall cost of the transaction. In order to properly assess this income tax effect, it is essential to understand the timing, character, and source of taxable income or loss that may result from the transaction. Timing refers to the need for determining the proper tax-reporting period and, therefore, concentrates on application of the correct tax accounting methodology (e.g., cash versus accrual, mark-to-market, etc.). Character considers the nature of the income (i.e., ordinary versus capital) and whether any special tax rates, limitations, or other rules apply. Source focuses on jurisdictional and related issues, such as where income should be subject to tax, ability to utilize foreign tax credits, and state and local apportionment, etc. Of course, a key tax consideration for most issuers is whether their transaction is considered a sale or financing under the tax rules. The term sale includes a sale, exchange, or other disposition that results in a realization of gain or loss for U.S. income tax purposes. It also may be possible to structure a transaction to meet the requirements for GAAP sale accounting while receiving financing treatment for tax commonly referred to as a debt-for-tax (DFT) structure. This can allow a securitizer to optimize results by reporting a gain on sale in their financial statements without incurring a current tax liability. The following discussion strives to address the more common questions and related factors that inevitably need to be considered when analyzing the tax accounting for a particular securitization structure: What is the tax impact of choosing an entity type? Owner Trust Structure From a tax perspective, the type of entity used in a securitization transaction is an important consideration. For an issuing entity that is not otherwise Certicate a corporation and does not qualify as an investment trust (e.g., an Holders owner trust, a limited liability company, or partnership) the so-called check-the-box rules provide flexibility in determining the tax treatment of such an entity. Absent an election by the taxpayer to treat the entity as an association (i.e., taxable as a corporation), these rules provide that a Trust domestic entity is considered a partnership if it has two or more members or is disregarded as an entity separate from its owner (DRE) if it has a single owner. A foreign entity is treated as a partnership if it has two or more members and at least one member does not have limited liability; an association (taxable as a corporation) if all members have limited liability; Note or disregarded as an entity separate from its owner if it has a single owner Holders that does not have limited liability. As a general matter, the owner of a DRE is treated as the direct owner of the assets held by the entity and the issuer of its debt. Note: the determination of whether a beneficial interest constitutes debt or equity for U.S. income tax purposes is a key consideration in applying the check-the-box rules.
7

Terry Meyers

Unless otherwise noted, all tax-related references are to the income tax principles contained in the Internal Revenue Code of 1986, as amended, and regulations thereunder as of December 31, 2009.

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Select U.S. Tax Considerations for Securitization Transactions Consideration Asset type limitations Debt or equity analysis required Time tranching allowable Restricted ownership/transferb Debt Equity Gain or loss recognition Transfer of assets to entity Transfer of beneficial interests Entity level taxation Equity holder treatment Owner of assets Issuer of debt Taxable income determination Floor on taxable income Yes Yes Holder level N/A Noe No
e

Investment Other trust entities No N/A N/A N/A No No Yes No No Yes Yes No No Noc Yes No
d a a

Corporations REMICs No Yes Yes No No Noc Yes Yes No No Entity level N/A
d c

Yes No Yes No Yes No Yes Noc No No Entity level Yes

Entity levele N/A

a Except mortgage securitizations subject to the Taxable Mortgage Pool rules. b Tax-withholding rules should be considered. c Special rules may apply d In the case of an equity interest e Except in the case of a Disregarded Entity

Investment Trust Structures The use of an investment trust can accomplish several objectives including no entity-level taxation and exemption from withholding tax. Under the tax rules, an investment trust is meant to include a trust that is not a business trust and either has a single class of Investment Trust Structures ownership interests representing undivided beneficial interest in the trust assets or multiple classes that are Certicate incidental to facilitating direct investment in the assets Holders of such trust such as creation of an interest only class or a senior/subordinate structure where principal and interest generally is paid pro rata but losses are Trust (Single Class) allocated to just one of the classes.
Interest Only Certicate Holders Principal Only Certicate Holders Senior Certicate Holders Subordinated Certicate Holders

Trust
(Multi-Class)

Trust
(Multi-Class)

In addition, there must be no power under the trust agreement to vary the investment of the certificate holders. An example of such a power to vary generally would include reinvestment of amounts collected on the trust assets (i.e., principal, interest, sales proceeds, etc) so a revolving structure would not qualify.

44

Securitization accounting

Corporate structures While special rules apply for certain corporate entities (e.g., regulated investment companies, REITs, subchapter S corporations, foreign corporations, etc.), a U.S. corporation generally is not used as the issuing entity for a securitization due to the potential imposition of an entity-level tax. However, non-U.S. corporations (or similarly treated entities) that do not engage in a U.S. trade or business generally are not subject to U.S. taxation and have been used regularly Corporate Structure for securitization transactions, such as CDOs/CLOs. These non-U.S. entities are Equity typically characterized as either passive foreign investment company (PFIC) or Shareholders controlled foreign corporation (CFC) for U.S. tax purposes and all income typically is considered to be from passive activities (interest, dividends, etc.). As a result, U.S. investors that hold interests in such a PFIC or CFC that are not characterized as debt for U.S. income tax purposes generally are subject to Corporation special rules. In the case of a PFIC an investor can choose to currently include their pro rata share of the PFICs net income (but not losses) in taxable income by making a qualified electing fund (QEF) election on IRS Form 8621. If the QEF election is not made, the investor may be subject to certain unfavorable interest charges. A U.S. investor who owns 10 percent or more of the total combined Note voting power of all classes of stock entitled to vote of such an entity that is Holders characterized as a CFC is required to currently include their pro rata share of the CFCs net income (but not losses) in taxable income. Real estate mortgage investment conduit structures A specific set of statutory tax rules provide for a specialized vehicle that can be used as the issuing entity when it comes to the securitization of mortgage loans. This vehicle is called a real estate mortgage investment conduit (REMIC). While a number of requirements and special rules apply, the REMIC structure provides securitizers with tax certainty as well as greater flexibility in structuring their transaction. For example, a REMIC generally is not subject to an entity-level income tax because its income is taxable to the owners of the interests in the REMIC. However, REMICs are subject to a 100 percent tax on their net income from certain prohibited transactions.
REMIC Structure

In addition, REMICs are not subject to the traditional rules that apply for determining whether a beneficial interest constitutes debt or equity for tax purposes. All REMIC regular interests are treated as debt for purposes of the tax rules, regardless of their legal form, and there is no limit on the number of regular interests that a REMIC may issue. A residual interest is defined as any interest that is not a regular interest. REMICs are permitted to have only one class of residual interest and it is not required to be entitled to any distributions from the REMIC. Although, the residual interest of a REMIC as defined by the tax rules is considered its equity interest for tax purposes, it typically does not represent an economic interest. Moreover, it commonly is considered to have a negative economic value due to the generally adverse tax consequences resulting from its associated phantom income and the statutory floor on residual holder taxable income described below. Hence, it is commonly referred to in the marketplace as a non-economic residual interest (NERD).

REMIC Residual Interest Holder

REMIC

REMIC Regular Interest Holders

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A REMIC is any entity that has: 1) 2) 3) 4)

5) 6)

In exchange for the greater flexibility and certainty, REMICs are subject to fairly stringent initial and ongoing qualification requirements. a valid REMIC election In addition, the REMIC sponsor is required to only regular interests or residual interests recognize gain or loss upon the sale, exchange, only one class of residual interests (and all distributions, if any, with or other taxable disposition of the REMICs respect to such interests are pro rata) regular and residual interests. Lastly, the taxable as of the close of the third month beginning after its start-up day and income reportable by a REMIC residual interest at all times thereafter, substantially all of its assets consist of qualified holder is subject to a floor, referred to as the mortgages and permitted investments excess inclusion rule. Based on this rule, the a calendar taxable year taxable income of a REMIC residual interest reasonable arrangements designed to ensure: holder for any taxable year may in no event be a. its residual interest is not held by disqualified organizations and less than the holders allocable portion of excess b. information necessary for imposition of tax on any transfer to a inclusion income for the same taxable year. The disqualified organization will be made available. amount of excess inclusion income is determined each calendar quarter and equals the excess of REMIC taxable income over an accrued amount based upon 120 percent of the applicable federal rate. In the case of a NERD, the amount of excess inclusion generally equals the taxable income of the REMIC. Important rule Absent a REMIC election, when time tranching is desired (i.e., a multiclass issuance with different maturities) in a mortgage securitization, the issuing entity may be characterized as a taxable mortgage pool (TMP) and become subject to an entity-level tax and additional special rules. The tax rules treat a TMP as a separate corporation that is subject to entity-level taxation and not includible in a consolidated tax return. Although special exemptions apply for REIT and certain other entities, a TMP generally refers to any entity (other than a REMIC) where: 1) substantially all of its assets are debt obligations, 2) more than 50 percent of those debt obligations are real estate mortgages, 3) the entity is the obligor under debt obligations with two or more maturities, and 4) payments on the debt obligations under which the entity is obligor bear a relationship to payments on the debt obligations that the entity holds as assets. How does the concept of consolidation apply for tax purposes? Similar to the accounting concept, consolidation may result in one or more legal entities or business operations joining together in the filing of a single report that consolidates their tax results and generally serves to eliminate the effect of intercompany transactions. Common examples include the filing of a consolidated federal income tax return or state tax filings that are made on a unitary or combined basis. Similar results occur where the issuing entity is characterized as a DRE. Consequently, when assets are first transferred to an SPE even if the transfer might qualify as a sale under the tax rules it may not result in a current federal income tax liability where the SPE is a wholly owned subsidiary of the transferor and is included in the transferors consolidated federal income tax return or is otherwise classified as a DRE. The key takeaway here is that GAAP and the tax rules do not always apply the concept of consolidation in a similar fashion. Also important, the answer for federal income tax purposes may not be the same for state tax purposes.

46

Securitization accounting

What are the entity level tax considerations for a securitization vehicle? Since any imposition of tax on the issuer will reduce the amount of funds otherwise available to pay investors, thereby increasing the overall cost of borrowing for the transferor, a primary objective is the selection of a vehicle that will not be subject to an entity-level tax. For REMICs, the tax answer is simple, regardless of the entitys legal form: as discussed above, a REMIC essentially is treated as a pass-through vehicle and generally not subject to an entity-level income tax. In the absence of a REMIC election, the preferred characterization would generally be either a partnership or a disregarded entity since neither is subject to a separate entity level income tax. The so-called checkthe-box regulations have made structuring to achieve either characterization a reasonably simple process. When is a securitization treated as a sale for tax? Generally, the income tax results of a transaction are decided based upon its substance, rather than its form, and, importantly, a sale is not always required for gain or loss recognition to occur for tax purposes. For example, certain assumptions of liabilities by the transferee made in connection with the transfer of assets may result in gain recognition. Typically, the determination of whether a transaction is properly characterized a sale for tax, rather than a mere pledge of the assets as security for a financing, requires a detailed analysis of the specific facts and circumstances of the transaction. The result will depend upon the answer to several questions, including: Who possesses the benefits and burdens of owning the transferred assets? Who exercises control over the assets? What is the form of the transaction? The determination of whether a transaction is considered a sale or a financing for tax purposes is often directly linked to the tax characterization of the beneficial interest that is being transferred. Consequently, the debt or equity question can be an important consideration for both securitizers and investors. If the transaction is characterized as the transfer of an ownership or equity interest in the assets, for tax purposes, the securitizer typically recognizes gain or loss to the extent of such transfer. Alternatively, if the attributes of the transaction result in characterization as a borrowing for tax purposes, the securitizer typically recognizes no Sale or Financing? Benefits and Burdens of Ownership Who bears the risk of loss? Who has the opportunity for gain? Who possesses the power to dispose of the assets? Does the agreement provide for a fixed price? Are the payment terms of the receivables and the certificates significantly different? Servicing Arrangement Who controls servicing of the assets? Who is obligated to collect receivables? Who bears the cost of collection? Is the transferee held harmless for acts of collection agent? Form of Transaction Are borrowers notified of change in receivable ownership? Who is liable for property, excise, sales or similar taxes? Does the transferor have the right to inspect the books and records of transferee? Is the transferee a shell subsidiary?

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gain or loss for U.S. income tax purposes. The investor is similarly interested in the characterization, since it can be an important consideration when determining the tax reporting and withholding tax requirements. The tax characterization of a beneficial interest ultimately depends upon the nature and degree of participation that the investor has in the Debt or Equity? activities/success of the issuing entity or the assets underlying the transaction. For example, The factors to be used in determining whether a security will be beneficial interests issued by a securitization considered debt or equity for U.S. federal income tax purposes trust that represent a passive investment to include: its holder, based on a limited risk of loss, 1) whether there is an unconditional promise on the part of the issuer to stable return, and a fixed maturity would be pay a sum certain on demand or at a fixed maturity date that is in the more consistent with debt issued in a lending reasonably foreseeable future; arrangement than an equity interest. 2) whether holders possess the right to enforce the payment of principal and interest; Alternatively, if the beneficial interest is more 3) whether the rights of the holders of the instrument are subordinate to closely tied to the overall performance and rights of general creditors; success of the issuing entity (or underlying 4) whether the instruments give the holders the right to participate in assets), it suggests that the beneficial interest is the management of the issuer; more akin to an equity investment. 5) whether the issuer is thinly capitalized; 6) whether there is identity between holders of the instruments and Invariably, the tax characterization of the stockholders of the issuer; beneficial interest will fall somewhere along the 7) the label placed upon the instrument by the parties; and continuum between pure debt and pure equity 8) whether the instrument is intended to be treated as debt or equity due to the blending of the risks, rewards, and for non-tax purposes, including regulatory, rating agency, or financial related contingencies negotiated by the parties. accounting purposes. Subject to much debate over the years, the tax rules for analyzing whether a beneficial interest represents debt or equity are the product of a variety of income tax rulings and court decisions. How is tax gain or loss determined? Once a transaction has been determined to result in a tax sale, the amount of gain or loss recognized generally is determined by comparing the net value received to the allocated tax basis of the beneficial interests sold but special rules can apply to limit or disallow the deductibility of losses where related parties participate. Tax basis typically differs from GAAP carrying value for various reasons that can stem from differences in accounting methodology; for example, the allowance for loan losses, while reducing GAAP carrying value, typically would not reduce tax basis. Differences also can result from the use of lower of cost or fair value (LOCOM) for GAAP and mark-to-market (such as can apply to dealers in securities, including loan originator/sellers) or non-mark-to-market for tax. Another common example is the recognition of a servicing asset for GAAP that is not recorded as an asset for tax purposes. Special rules for REMICs Additional rules apply to the sponsor of a REMIC. The tax rules define a REMIC sponsor as any person who directly or indirectly transfers qualified mortgages and related assets to a REMIC in exchange for its regular and residual interests. The tax rules provide that no gain or loss is recognized as a result of the
48 Securitization accounting

initial transfer of assets to a REMIC with the sponsors tax basis in the assets transferred to the REMIC simply being allocated among the regular and residual interests issued by the REMIC in proportion to their fair market value. However, gain or loss generally would be recognized upon the subsequent sale of the REMIC interests (including the sale of the REMIC regular interests). The amount of such gain or loss would equal the difference between the sponsors net proceeds (i.e., proceeds received, less selling expenses) and the allocated tax basis of the REMIC interest sold. Generally, gain or loss attributable to REMIC interests that are retained by the sponsor is deferred and recognized over time. The amount of such unrecognized gain or loss is equal to the difference between the fair market value of the retained REMIC interest at the start-up date of the REMIC and its allocated tax basis. For REMIC regular interests, unrecognized gain is recognized for tax purposes in accordance with rules similar to those used to account for Market Discount and unrecognized loss is recognized in a manner similar to Market Premium (see related discussion What about secondary market purchases?). For REMIC residual interests, unrecognized gain and loss is included in the sponsors income ratably over the anticipated weighted-average life of the REMIC. How is periodic income for debt instruments determined? Once the securitization has been completed, the securitizer and investors must begin to report their ongoing taxable income from the related beneficial interests that they have either acquired or retained. Accordingly, the tax accounting will depend to some degree upon whether the beneficial interest held constitutes debt or equity for tax purposes. The tax rules provide special rules for interest, discount, and premium and distinguish between debt instruments acquired at the issue date and those purchased in the secondary market. Typically investors must account for each item separately, based upon the applicable tax rules. However, the tax rules also provide an election that allows for all interest, discount, and premium of a debt instrument to be accounted for together. Generally, the tax accounting rules for a debt instrument depend in part upon whether the debt is subject to acceleration of principal by reason of prepayment (PDI) or otherwise provides for contingent payments (CPDI). The mere possibility of impairment due to insolvency, default, or similar circumstances does not cause a debt instrument to provide for contingent payments. Common examples of PDI include: REMIC regular interests, other MBS/ABS, mortgage and consumer loan pools, etc. Examples of CPDI include: a debt instrument that provides for a payment based upon the gross receipts of the issuer or one that pays based upon the fluctuations in the price of a publicly traded stock. Since PDIs are the more common type of debt instrument encountered in securitization transactions, we will limit our discussion to the tax rules that generally apply to them. Similarly, for ease of illustration, we will not discuss the effects of the mark-to-market method of tax accounting that generally can apply in the case of dealers in securities and electing traders in securities. Interest For tax purposes, interest falls into two general categories: qualified stated interest (QSI) and non-qualified stated interests (non-QSI). Generally, QSI includes all interest that is unconditionally payable at least annually i.e., typical non-PIK-able coupon interest. QSI is considered to be interest for tax purposes. While normal tax accounting methods generally apply to its recognition, QSI earned with respect to a REMIC regular interest must be recognized on the accrual method, regardless of the general tax
Chapter 6 49

accounting method of the holder. All payments other than QSI and principal are non-QSI payments and typically are accounted for as part of original issue discount (OID). Original issue discount Subject to certain de minimis rules, a debt instrument with an issue price that is less than its stated redemption price at maturity (SRP) generally is considered to have OID. The SRP of a debt instrument equals the sum of all payments expected to be made with respect to the debt instrument other than QSI (i.e., the sum of principal and non-QSI payments). Debt instruments subject to the PAC method Any regular interest in a REMIC or qualified mortgage held by a REMIC, Any other debt instrument if payments under such debt instrument may be accelerated by reason of prepayments of other obligations securing such debt instrument (or, to the extent provided in regulations, by reason of other events), or Any pool of debt instruments the yield on which may be affected by reason of prepayments (or to the extent provided in regulations, by reason of other events). Note: The above referenced regulations have not yet been issued. OID accrues and is recognized currently based upon the debt instruments yield to maturity (tax yield) and there are two methods that can apply for purposes of determining the amount to be accrued. The Standard Method [IRC 1272(a)(3)] applies to debt instruments that are not CPDI and not otherwise subject to the Prepayment Adjustment Catch-up (PAC) Method [IRC 1272(a)(6)]. Note: The PAC methodology was used in the Simplified Tax Example below. The methods differ both in their determination of tax yield and in the amount of OID that must be recognized each period. Under the PAC Method, the determination of tax yield allows for a prepayment assumption (the Tax Prepayment Assumption) while the Standard Method does not. Regardless of the method employed, the tax rules do not provide for a loss assumption to be used when determining the tax yield. See When are losses taken into account for tax purposes?

In addition, the legislative history to the PAC Method clarifies that a negative OID accrual is not permitted. Instead, the amount of OID is treated as zero for the period and the computation of OID for the next period would be made as though that period and the preceding period were a single period (i.e., OID would not be accrued until the cumulative result produces a positive amount). What about secondary market purchases? While discount or premium that results from an investors purchase of a debt instrument in the secondary market (i.e., after the issue date) does not affect the issuers taxable income calculation, it must be considered in determining the ongoing income of the investor. Premium There are two types of premiums under the tax rules. We will refer to the first as market premium, the second as acquisition premium. Market premium occurs when a debt instrument is acquired at a price that is greater than its SRP. If the debt instrument was issued with OID, only the market premium is accounted for by the holder and the holder is not required to account for the OID. While holders are not required to amortize market premium for taxable debt instruments, they may elect to amortize it based upon the debt instruments yield to maturity (e.g., its tax yield). In the case of debt instruments that provide for two or more principal payments, the legislative history suggests that holders may apply the rules similar to those provided for the accrual of market discount (discussed below).

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Acquisition premium occurs when a debt instrument is purchased at a price greater than its adjusted issue price (AIP), but at a price that is less than its SRP. In this case, the holder must continue to account for OID from the debt instrument. The amortization of acquisition premium is mandatory and the amount amortized each period equals the product of the OID accrual for the period and the fixed ratio of acquisition premium to the OID remaining at the holders date of acquisition. A debt instruments AIP equals its issue price increased for previous accruals of OID and decreased for payments of principal and non-QSI. Market discount A debt instrument generally has market discount when it is acquired subsequent to its date of issuance date for a price that is less than its SRP (or in the case of a debt instrument issued with OID, for a price less than its AIP). Market discount is generally accrued by the holder ratably over the period between its purchase date and maturity date, based upon the number of days held during the period. Alternatively, the holder can elect to accrue market discount based upon a constant interest rate. For debt instruments that provide for two or more principal payments, a special rule applies that requires market discount to be accrued based upon a method provided in the regulations. Although these regulations have not yet been issued, the legislative history for the rule provides that a holder may accrue market discount based upon either a constant interest method or an applicable ratio method (market discount accrual ratio [MDAR]). The MDAR that applies will vary depending upon whether the debt instrument was issued with OID. The Stated Interest Ratio method applies to debt instruments issued without OID and the OID Ratio method applies to debt instruments issued with OID. Note: The MDAR, as well as other information that can be helpful in determining a holders amount of QSI and OID from REMIC regular interests and certain other debt instruments is generally available from the issuers representative each calendar quarter upon request and contact information is published in IRS Publication 938 Real Estate Mortgage Investment Conduit (REMICs) Reporting Information (And Other Collateralized Debt Obligations [CDOs]). Generally, accrued market discount is not recognized until the debt instrument is sold or otherwise disposed of by the holder and is then recognized as ordinary income to the extent of any resulting gain. The amount of accrued market discount for debt instruments that provide for two or more principal payments also is recognized as ordinary income to the extent of any principal payments received. Alternatively, the holder may make an election to recognize market discount currently as it accrues. Note: The amount of a holders deductible net direct interest expense may be limited where market discount has accrued, but not been recognized.

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Tax accounting methods Constant interest methods IRC 1272(a)(3) The standard method [a x b - c] The amount of OID accrued generally equals the product of (a) the debt instruments AIP at the beginning of the period and (b) the Tax Yield of the debt instrument, less (c) the amount of QSI for the period. IRC 1272(a)(6) The PAC method [a + b - c] The amount of OID accrued generally equals the sum of (a) the present value of cash flows remaining at the end of the period (based upon the tax prepayment assumption) and (b) any principal and non-QSI payments during the period, less (c) the debt instruments AIP at the beginning of the period. The MDAR method [a x b] The amount of market discount accrual equals the product of (a) the MDAR for the period and (b) the amount of market discount remaining (i.e., not previously accrued) at the beginning of the accrual period. MDARs [a / b] Stated Interest Ratio equals (a) the Interest (other than OID) for the accrual period divided by (b) the sum of such Interest and the interest (other than OID) remaining at the end of the period, based upon the tax prepayment assumption. OID Ratio equals (a) the OID for the accrual period divided by (b) the sum of such OID plus the OID remaining at the end of the period based upon the tax prepayment assumption. Acquisition premium [a x b] The amount of amortization equals the product of (a) the OID accrual for the period and (b) the fixed ratio of acquisition premium to the OID remaining at the holders date of acquisition. What is the tax accounting that applies to beneficial interests that are classified as equity for tax purposes? For owners of investment trusts and similarly disregarded entities, the determination of taxable income or loss is made at the investor level. For other entities, the determination of taxable income or loss generally is made at the entity level. In each case, the rules described above for determining the ongoing income (and expense) from debt instruments continue to apply. A natural, yet at times curious, byproduct of these tax accounting calculations is phantom income. Phantom income is the direct result of differences that can exist between the weighted-average Tax Yield on the debt instruments held by the issuing entity and the weighted-average Tax Yield on the debt instruments issued by the entity. For example, in a traditional sequential pay structure while the weighted-average yield on the pool of debt instruments held by the issuing entity can remain fairly

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Securitization accounting

constant over the life of the transaction, the weighted-average yield on the issued debt will adjust over time as the various debt classes pay down possibly resulting in phantom income. While the cumulative amount of phantom income/loss will ultimately come to zero the present value of the associated tax effect is often negative, increasing the overall cost of the transaction. The desire to avoid this phantom income effect and associated excess inclusion income (described above) has led REMIC sponsors to routinely pay an inducement fee in order to dispose of the REMIC residual interests created in the REMIC securitization process. When are losses taken into account for tax purposes? Generally speaking, the effect of less than desirable credit performance may only be taken into account for tax purposes once it can be demonstrated that an actual credit event has occurred. Moreover, the tax rules do not permit a loss assumption to be made when projecting the cash flows to be used in determining the tax yield of a debt instrument. Consequently, a reserve established based upon the general expectation that credit losses will occur in future is not deductible for tax purposes. However, the specific write-off of a debt instrument due to a credit loss may result in a properly deductible tax expense. Understandably, this can lead to wide differences between GAAP and tax when it comes to the amount of income that is reported, possibly adding to the amount of phantom income. Non-accrual of interest The tax rules require that interest income continue to be accrued to the point it is no longer collectible. In those circumstances where interest has been properly accrued and is subsequently determined to be uncollectible, the holder may not reverse the accrual, but may seek a bad debt expense or loss deduction (see below). If, however, it can be demonstrated that the interest income is uncollectible at the date it otherwise would be accrued, then the accrual of interest is not required. For this purpose, interest would be considered uncollectible where based upon the surrounding facts and circumstances no reasonable expectation exists at the time of accrual that the interest will be collected. Bad debt expense With respect to bad debt expense, typically a holder is entitled to a deduction when there is clear evidence that a debt instrument has become wholly or partially worthless. In the case of a deduction for partial worthlessness, the holder must be able to demonstrate that the debt instrument was charged-off on the holders books and records during the same tax year that the deduction is taken. Special rules can apply to require the recognition of gain or loss upon foreclosure of a loan to the extent that the fair market value (FMV) of property acquired in foreclosure differs from the holders tax basis in the loan. In addition, a modification to the terms of a debt instrument that is considered to be significant under the tax rules can result in the recognition of taxable gain or loss. The ability to deduct bad debt expense does not apply to certain debt instruments that are considered a security for this purpose such as debt issued by a corporation in registered form. Also, non-corporate holders are only entitled to a deduction if the debt instrument was created or acquired in connection with the holders trade or business. The inability to meet this requirement would cause such a loss to be available only at the time of complete worthlessness and to be characterized as a short-term capital loss.

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Worthless securities In the case of a security that is a capital asset in the hands of the investor and becomes worthless during the taxable year if the investor does not otherwise qualify for a bad debt expense (described above) the loss is treated as resulting from the sale or exchange of a capital asset on the last day of the same taxable year. The term security includes a share of stock in a corporation; a right to subscribe for, or to receive, a share of stock in a corporation; or a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form. A simplified tax example The table below highlights the potential tax results and contrasts them against the possible GAAP results for a particular transaction. The example shows the gain and ongoing income to the transferor of residential mortgages into a hypothetical senior-subordinated structure. Assume that the beneficial interests are entitled to principal payments on a pro rata basis with all credit losses being applied first to reduce the Class B balance to zero before any reduction in the Class A balance. The example compares the potential results on a REMIC, non-REMIC sale for tax (SFT), and a DFT basis to the parallel GAAP sale accounting results. The example also highlights the ongoing taxable income results of the tax alternatives. Assumptions Loans Balance Rate Term Price/FMV% Class % Sold Proceeds $ FMV $ Selling expenses Carrying Value Tax Basis CPR Tax Yields: REMIC SFT DFT 8.09% 8.20% 8.22% 7.32% 7.32% 7.32% 10.13% 10.13% 400 97,000 99,000 0% 1,500 387 100,000 8.00% 10 1.5% 102.0% 100% 81,600 90% 15% 2,700 15,300 13 0% 0 (2)* 0.25% Servicing Class A 80,000 7.75% Class B 20,000 7.75% Class R

* Represents the present value of the expected tax cost from the phantom income of the REMIC Residual Interest.

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Securitization accounting

Comparative Gain on Sale REMIC Class A proceeds Class B proceeds Retained interest FMV Servicing asset FMV Subtotal Less: Tax basis/carrying value Selling expenses Total gain Recognized Deferred GAAP gain Tax basis Carrying value Servicing asset Tax gain 99,000 400 200 108 92 3,700 (99,000) 97,000 (1,500) 200 99,000 400 200 19 181 400 97,000 400 3,700 3,700 81,600 2,700 15,300 99,600 SFT 81,600 2,700 15,300 99,600 DFT 81,600 2,700 84,300 GAAP 81,600 2,700 15,300 1,500 101,100

Note: The amount of recognized gain for the REMIC alternative equals the total proceeds of $84,300, less selling expenses of $400 and the allocated tax basis of $83,792 ($99,000 x ($84,300/$99,600)). The amount of recognized gain for the SFT alternative equals $14,927 which represents the sum of the proceeds from the Class B ($2,700), less selling expenses of $13 ($400 x (2,700/($2700 + $81,600)), plus $12,240 (15 percent x the Class A proceeds (i.e., the Class B holders share of the Class A liability)), less $14,907 (the sum of allocated tax basis $14,850 ($99,000 x 15 percent) and allocated Class A issuance expense of $58 ($387 x 15 percent)). The DFT illustration assumes both Class A and Class B are characterized as debt for income tax purposes.

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Comparative Taxable Income (Loss) REMIC Pd 0 1 2 3 4 5 6 7 8 9 10 Total 108 1,577 1,477 1,367 1,247 1,114 969 809 634 442 231 9,975 Class Ra 12 8 5 2 (1) (4) (5) (6) (6) (5) 0 Retained 1,550 1,455 1,349 1,233 1,105 964 806 634 444 235 9,775 Sale-for-Tax Gain/ (Loss) Retainedb 108 15 14 13 12 10 9 8 6 4 1 200 1,587 1,488 1,378 1,258 1,125 979 818 642 447 234 9,956 Debt-for-Tax Gain/ (Loss) Gain/ (Loss) Retainedb 19 19 1,589 1,490 1,381 1,260 1,127 981 820 643 449 235 9,975

a - Note the cumulative phantom income/loss of the Class R equals zero. b - Reflects applicable portion of debt issuance cost amortization. An investor example: Assume Much Pursued Investment Fund (MPIF) purchased REMIC regular interest Class O for a price of $65,000 on the first day of the January accrual period. The Class O has OID and no QSI and has made no principal or interest payments since the investors purchase. At the end of the quarter, MPIF contacted the REMIC and obtained a statement containing the following information for the calendar quarter: Period Jan-10 Feb-10 Mar-10 Total QSI 0 0 0 0 OID 2,000 5,000 3,200 $10,200 Beginning AIP 80,000 82,000 87,000 MDAR 0.10000 0.27778 0.24615

Based upon this information, MPIF determined that its taxable income for the calendar quarter was as follows: Period Jan-10 Feb-10 Mar-10 Total MDR 15,000 13,500 9,750 MDAR 0.10000 0.27778 0.24615 MD Accrued 1,500 3,750 2,400 $7,650

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Securitization accounting

Since no principal payments have been made during the accrual periods, if MPIF has not otherwise elected to currently recognize market discount, the total amount of income to be reported by MPIF for the first calendar quarter would be $10,200 the amount of OID. If MPIF had elected to currently recognize market discount, the total income to be reported would be $17,850 (10,200 + 7,650). Note: The issuer provided information shown is based upon investors specific facts for ease of illustration only; actual information provided by the issuer is typically on a per unit of original face amount or similar basis. Does the transition to FAS 167 impact my taxes? First, the good news: neither the determination of whether a securitization is a sale or financing for tax purposes nor the ongoing determination of taxable income from the transaction is affected by FAS 167. On the other hand, the change in GAAP treatment will have a direct impact on income tax accounting in particular, on the accounting for deferred taxes. Consequently, regardless of whether FAS 167 results in assets and liabilities that are moving on or off the GAAP balance sheet at the adoption date (and, most likely on), the resulting change in the difference between pre-transition carrying value and tax basis will need to be recorded and tracked as a component of deferred taxes post adoption.

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Chapter 7 How do you determine gain or loss on a sale?

Say what you want about FAS 166 and 167, at least the calculation of gain or loss on sale of assets has been greatly simplified. There are three principal reasons for this: achieving sale accounting and deconsolidations is now a higher hurdle than had been previously the case under FAS 166, one can sell only an entire financial asset, an entire pool of assets, or a participating interest; no part sale, part financing acquired interests are initially recorded at fair value rather than allocated cost basis Many of the steps in the process of calculating a gain or loss on sale will sound familiar. It remains useful to remember that for a securitization that has achieved sale accounting, the transferor has sold an entire pool of assets. There are no longer retained pieces any beneficial interests received are all proceeds! (For participating interests, please see What about sales of participating interests? below.) Sellers still must first accumulate the elements of carrying value of the pool of assets securitized, including any premiums and discounts, capitalized fees or costs, LOCOM valuation reserves, and allowances for losses. Next, identify any assets received and any liabilities incurred as part of the securitization. Finally, carefully estimate the fair values of every element received or incurred based on current market conditions. Use realistic assumptions and appropriate valuation models and only consider existing assets actually transferred (without anticipating future transfers). Then, for those transfers that qualify as a sale: Recognize gain or loss on the assets sold by comparing the net sale proceeds (after transaction costs and after liabilities incurred) to the carrying value attributable to the assets sold. Record as proceeds and carry on the balance sheet at fair value, any beneficial interest received in the transferred assets which may include a separate servicing asset and debt or equity instruments in the SPE. [860-20-30-1] Subtract from proceeds and record on the balance sheet the fair value of any new liabilities issued, including guarantees, recourse obligations, or derivatives, such as put options written, forward commitments, interest rate, or foreign currency swaps. [860-20-30-2] Financial modeling of securitization transactions is an integral part of the accounting process, both at the date of the transaction and on an ongoing basis. Reasonable financial modeling requires using quantitative processes that appropriately reflect the nature of the assets securitized, the structural features and terms of the securitization transaction and the applicable accounting theory. It also requires accurate data about current amounts and balances. Finally, it requires current market valuation information (such as yield curves, credit spreads, and derivative prices) and supportable assumptions about future events (such as customer prepayment behavior, default probability, and loss severity). Securitization transactions are too complex to be able to analyze intuitively at the level of precision required for financial reporting.
58 Securitization accounting

How is gain or loss calculated in that rare revolving structure that does not have to be consolidated? Gain or loss recognition for relatively short-term receivables, such as credit card balances, draws on home equity lines of credit, trade receivables, or dealer floor plan loans sold to a relatively long-term revolving securitization trust, is limited to receivables that exist and have been sold (and not those that will be sold in the future pursuant to the revolving nature of the deal). Recognition of servicing assets is also limited to the servicing for the receivables that exist and have been sold. [860-20-55-31] A revolving securitization involves a large initial transfer of balances generally accounted for as a sale. Ongoing, smaller subsequent months transfers funded with collections of principal from the previously sold balances (transferettes) are each treated as separate sales of new assets with the attendant gain or loss calculation, provided that these transfers meet the unit of account definition discussed above. [86010-55-17H] The recordkeeping burden necessary to comply with these techniques can be quite onerous, particularly for master trusts. The implicit forward contract to sell new receivables during a revolving period, which may become valuable or less so as interest rates and other market conditions change, is to be recognized at its fair value at the time of sale. Its value at inception will be zero if entered into at the market rate. FAS 166 does not require securitizers to mark the forward to fair value in accounting periods following the securitization. (Note: the application of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, [815 generally] may, but this is outside the scope of this booklet, as are any considerations of electing fair value accounting under Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities [825-10-15]) Certain revolving structures use what is referred to as a bullet provision as a method of repaying principal to their investors. Under a bullet provision, during a specified period preceding liquidating distributions to investors, cash proceeds from the underlying assets are reinvested in short-term investments (as opposed to continuing to purchase revolving period receivables). These investments mature to make a single-bullet payment to certain classes of investors on a predetermined date. In a controlled amortization structure, the investments mature to make a series of scheduled payments to certain classes of investments on predetermined dates. The bullet or controlled amortization provision should be taken into account in determining the fair values of the assets obtained by the transferor and transferee. [860-20-55-16] The FASB staff concluded that it is inappropriate to report the receivables for accrued fee and finance charge income on the investors portion of the transferred credit card receivables, commonly referred to as accrued interest receivable (AIR), as loans receivable or with other terminology implying that it has not been subordinated to the senior interests in the securitization. The AIR asset should be accounted for as a beneficial interest received in the pool. FAS 166 does not specifically address the subsequent measurement of beneficial interests other than those that cannot be contractually prepaid or settled in such a way that the owner would not recover substantially all of its recorded investment. Entities should follow existing applicable accounting standards, including Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FAS 5) [450 generally] in subsequent accounting for the AIR asset. FAS 5 addresses the accounting for various loss contingencies, including the collectibility of receivables. [860-20-55-17]
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Is there a sample gain on sale worksheet that I can use as a template? A term securitization example: Assumptions (all amounts are hypothetical and the relationships between amounts do not purport to be representative of actual transactions): Aggregate principal amount of pool $ 100,000,000 Net carrying amount (principal amount + accrued interest [if it has to be remitted to the trust] + purchase premium + deferred origination costs - deferred origination fees - purchase discount - loss reserves) $ 99,000,000 Classes IO and R are acquired by transferor Deal structure Class A Class B Class IO Class R TOTAL $100,000,000 * Including accrued interest Servicing asset at fair value Up-front transaction costs (underwriting, legal, accounting, rating agency, printing, etc.) Calculation of gain: Total proceeds: Total cash from bond classes sold (net of transaction costs) FMV, Class IO FMV, Class R FMV, Servicing asset Net proceeds (with accrued interest, after transaction costs) Net carrying amount Pretax gain Journal entries Cash Servicing asset Class IO Class R Net carrying amount of loans Pretax gain on sale Debit $ 98,800,000 700,000 1,500,000 1,000,000 Principal amount $ 96,000,000 4,000,000 Price* 100 95 Fair value $ 96,000,000 3,800,000 1,500,000 1,000,000 $102,300,000 $ 700,000 $ 1,000,000

$ 98,800,000 1,500,000 1,000,000 700,000 102,000,000 99,000,000 $ 3,000,000 Credit

$ 99,000,000 3,000,000

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Securitization accounting

A credit card example Each month, during the revolving period, the investors share of principal collections would be used to purchase new receivable balances (transferettes) and an analysis similar to the one below would be made with a new gain or loss recorded. This example illustrates the gain calculation a securitizer would prepare at the transactions inception, assuming that the transfer is to an unconsolidated entity and transaction achieves sale accounting (at this writing, a significant assumption). Assumptions (all amounts are hypothetical and the relationships between amounts do not purport to be representative of actual transactions) Aggregate principal amount of pool $650,000,000 Carrying amount, net of specifically allocated loss reserve $637,000,000 Fair value of cash collateral account $5,000,000 Value of fixed-price forward contract for future sales 0 Up-front transaction costs $4,000,000 Calculation of proceeds Principal amount Class A $ 500,000,000 Class B 25,000,000 Initial funding of cash collateral account Fair value of beneficial interest in overcollateralization IO strip Beneficial interest in cash collateral account Allocated transaction costs (assumes 25 percent allocation to the initial sale)8 TOTAL Calculation of gain Net proceeds after transaction costs Carrying amount Pretax Gain Journal Entries Cash IO strip Cash collateral account Sellers interest Deferred transaction costs Pretax gain on sale Net carrying amount of loans Debit $ 514,000,000 10,000,000 5,000,000 125,000,000 3,000,000 Price 100 100 Proceeds $ 500,000,000 25,000,000 (7,000,000) 125,000,000 10,000,000 5,000,000 (1,000,000) $ 657,000,000

$ 657,000,000 637,000,000 $ 20,000,000 Credit

$ 20,000,000 637,000,000

EITF 88-22, Securitization of Credit Card and Other Receivable Portfolios

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What about sales of participating interests? Assume Commercial Loan Bank and Trust (CLBT) has sold an eight-tenths participating interest in a commercial loan with a carrying amount of $20,000,000 to Partaker Bank for $15,200,000. Additionally, CLBT has sold a 10 percent participating interest in the same loan to Group Bank for $1,900,000. The total cash proceeds are $17,100,000, implying that the fair value of the loan is $19,000,000. Thus: Basis allocation of carrying value % of total Fair value fair value $ 15,200,000 80% 1,900,000 10 1,900,000 10 $ 19,000,000 100% Allocated Allocated carrying amount carrying amount ($20 MM x %) Sold Retained $ 16,000,000 $ 16,000,000 2,000,000 2,000,000 2,000,000 2,000,000 $ 20,000,000 18,000,000 $ 2,000,000 17,100,000 $ 900,000 Debit $ 17,100,000 900,000 Credit

Component Sold to Partaker Sold to Group Interest held by CLBT TOTAL Net proceeds Pretax loss

Journal entries Cash Loss on sale Net carrying amount of loans

$18,000,000

CLBTs remaining 10 percent interest would stay on the books at a basis of $2,000,000. This participation transaction would not give CLBT an opening to elect to carry that interest at fair value. The example above may be slightly oversimplified. In the first instance, even though they are buying their interests at the same time, Partaker and Group might pay somewhat different prices. Also, the example ignores servicing, which could result in a liability (if the servicing fee would not fairly compensate a substitute servicer) or a small asset (however, the fee cannot be significantly above fair compensation and still meet the participating interest definition). How do I calculate fair value? Because it would be unusual for a securitizer to find quoted market prices for most financial components arising in a securitization, the measurement process requires estimation techniques. FAS 166 discusses these situations as follows: The underlying assumptions about interest rates, default rates, prepayment rates, and volatility should reflect what market participants would use. Estimates of expected future cash flows should be based on reasonable and supportable assumptions and projections. All available evidence should be considered and the weight given to the evidence should be commensurate with the extent to which the evidence can be verified objectively. Please see Chapter 8, How do I measure and report fair value information? What if I cant estimate fair value? The FASB, in issuing FAS 166, has eliminated the practicability exception that existed under FAS 140, thus intimating that the transferor should be able to determine all fair values.
62 Securitization accounting

How do I record credit risk? Is it part of the beneficial interest in the asset? As discussed in Chapter 8, How do I measure and report fair value information?, the transferor should focus on the source of cash flows in the event of a loss by the trust. If the trust can only look to cash flows from the underlying financial assets, the transferor is absorbing a portion of the credit risk through its beneficial interest. It should not record a separate obligation. Possible credit losses from the underlying assets do affect, however, the accounting for and the measurement of the fair value of the transferors beneficial interest. In contrast, if the transferor could be obligated to reimburse the trust beyond losses charged to its beneficial interest (i.e., it could be required to write a check to reimburse the trust or others for credit-related losses on the underlying assets or the trust/investors have the right to put assets back to the transferor), a separate liability should be recorded at fair value on the date of transfer. Caution: Should this fact pattern present itself, special care should be taken in the determination of whether the transferor should consolidate the transferee and if legal isolation has been achieved. When do I record an asset for servicing? An entity shall recognize and initially measure at fair value a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in either of the following situations: A servicers transfer of an entire financial asset, a group of entire financial assets, or a participating interest in an entire financial asset that meets the requirements for sale accounting An acquisition or assumption of a servicing obligation of financial assets; such servicing obligation does not relate to financial assets of the servicer (or its consolidated affiliates included in the financial statements being presented). [860-50-25-1] A servicer that transfers or securitizes financial assets in a transaction that does not meet the requirements for sale accounting and is accounted for as a secured borrowing shall not recognize either a servicing asset or a servicing liability. [860-50-25-2] For transfers of financial assets that are sales, if the benefits of servicing are expected to be more than adequate compensation to service the assets, a servicing asset must be created. [860-50-25-1] This would best be evidenced by the ability to receive (as opposed to pay) cash upfront if the rights and obligations under the servicing contract were to be sold to another servicer. Conversely, if the benefits of servicing are less than adequate compensation, a servicing liability should be recorded. If the benefits of servicing are deemed to be equivalent to the amount determined to be adequate compensation, neither an asset nor a liability need to be recorded. A servicer of the assets commonly receives the benefits of servicing revenues from contractually specified servicing fees, late charges, and other ancillary revenues, including float and incurs the costs of servicing those assets. Typically in securitizations, the benefits of servicing are expected to equal or exceed adequate compensation to the servicer. Adequate compensation is the amount of benefits of servicing that would fairly compensate a substitute servicer, should one be required. Adequate compensation includes the profit that would be demanded in the marketplace and is expected to vary based on the nature of the assets being serviced. Consequently, the goal, when estimating the value of servicing, is to determine fair value; that is, what a successor servicer would pay or charge to assume the servicing. Therefore, when estimating the benefits
Chapter 7 63

of servicing, the benefits that should be included in the estimation model are those benefits that successor servicers would consider to the extent that successor servicers would consider them. The entity should estimate the value of the ancillary rights to benefit from the cash flows, such as late charges. [860-50-30-6] Similarly, when estimating the fair value of servicing, the estimated costs of servicing should be representative of those costs in the marketplace and should include a profit assumption equal to the profit demanded in the marketplace. Adequate compensation is determined by the marketplace; it does not vary according to the specific servicing costs of the servicer. Therefore, a servicing contract that entitles the servicer to receive benefits of servicing just equal to adequate compensation, regardless of whether the servicers own servicing costs are higher or lower, does not result in recognizing a servicing asset or servicing liability. As such, it stands to reason that any asset value that a particular servicing arrangement has is attributable to the excess of the contractual servicing fee over the level of adequate compensation. Likewise, the amount of a servicing liability would be determined by how far short the contractual servicing fee, in combination with all ancillary fees, fell below the adequate compensation level. FAS 166 makes no distinction between normal servicing fees and excess servicing fees. The distinction made is between contractually specified servicing fees and rights to excess interest (IO strips). Contractually specified servicing fees are all amounts that, in the contract, are due the servicer in exchange for servicing the assets. These fees would no longer be received by the original servicer if the beneficial owners of the serviced assets (or their trustees or agents) were to exercise their actual or potential authority under the contract to shift the servicing to another servicer. [860-50-25-7] Depending on the servicing contract, those fees may include: the contractual servicing fee, and some or all of the difference between the interest collected on the asset being serviced and the interest to be paid to the beneficial owners of those assets.

EXAMPLE: Financial assets with a coupon rate of 10 percent are securitized. The passthrough rate to holders of the SPEs beneficial interests is 8 percent. The servicing contract entitles the seller-servicer to 100 basis points as servicing compensation. The seller is entitled to the remaining 100 basis points as excess interest. Adequate compensation to a successor servicer for these assets is assumed to be 75 basis points. The chart graphically depicts the arrangement.

Basis points
200 175 150 125 100 75 50 25 0 Adequate compensation = 75 bps Servicing asset = 25 bps Contractual servicing fee = 100 bps IO strip = 100 bps

Servicing assets created in a securitization are initially measured at fair value and are considered to be part of proceeds. If a transferor sells a participating interest in an entire financial asset, it would recognize a servicing asset or a servicing liability only related to the participating interest sold. Rights to future interest income from the serviced assets in amounts that exceed the contractually specified servicing fees should be accounted for separately from the servicing assets. Those amounts are not servicing assets they are IO strips to be accounted for as described in the chart at the end of the chapter.
64 Securitization accounting

An entity shall subsequently measure each class of servicing assets and servicing liabilities using one of the following methods: a. Amortization method: Amortize servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income (if servicing revenues exceed servicing costs) or net servicing loss (if servicing costs exceed servicing revenues) and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. b. Fair value measurement method: Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value of servicing assets and servicing liabilities in earnings in the period in which the changes occur. [860-50-35-1] A transferor/servicer is able to make the above election separately for each class of servicing assets and servicing liabilities, but needs to apply the same measurement method subsequently to each servicing asset and servicing liability in the same class. Classes of servicing assets and servicing liabilities shall be identified based on (a) the availability of market inputs used in determining the fair value of servicing assets or servicing liabilities, (b) an entitys method for managing the risks of its servicing assets or servicing liabilities, or (c) both. [860-50-35-3] Once an entity elects a measurement method for a class of servicing assets and servicing liabilities, that election shall not be reversed. Changes in fair value should be reported in earnings for servicing assets and servicing liabilities subsequently measured at fair value. [860-50-35-1] In order to subsequently evaluate and measure impairment, each class of separately recognized servicing assets that are measured using the amortization method should: 1) stratify the servicing assets within a class based on one or more of the predominant risk characteristics of the underlying financial assets. Those characteristics may include financial asset type, size, interest rate, date of origination, term, and geographic location. 2) recognize impairment through a valuation allowance for an individual stratum. The amount of impairment recognized separately shall be the amount by which the carrying amount of servicing assets for a stratum exceeds their fair value. The fair value of servicing assets that have not been recognized shall not be used in the evaluation of impairment. 3) adjust the valuation allowance to reflect changes in the measurement of impairment subsequent to the initial measurement of impairment. Fair value in excess of the carrying amount of servicing assets for that stratum, however, shall not be recognized. [860-50-35-9] FAS 166 does not address when an entity should record a direct write-down of recognized servicing assets as opposed to a valuation allowance. For servicing liabilities subsequently measured using the amortization method, if subsequent events have increased the fair value of the liability above the carrying amount, for example, because of significant changes in the amount or timing of actual or expected future cash flows relative to the cash flows previously projected, the servicer shall revise its earlier estimates and recognize the increased obligation as a loss, in earnings. [860-50-35-11] An entity that transfers its financial assets to an unconsolidated entity in a transfer that qualifies as a sale in which the transferor obtains the resulting securities and classifies them as debt securities held-to-maturity in accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments
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in Debt and Equity Securities, (FAS 115) [320 generally] may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced. [860-50-25-4] Servicing is not a financial asset under FASB 166. Accordingly, there is a higher threshold analysis of risks and rewards to achieve sale accounting when mortgage servicing rights are transferred. See EITF Issues No. 90-2 1 and 95-5, Determination of What Risks and Rewards, If Any, Can Be Retained and Whether Any Unresolved Contingencies May Exist in a Sale of Mortgage Loan Servicing Rights (EITF 95-5) [860-50-40-3 through 5]. FASB recognized that the difference in accounting between servicing fees and IOs could lead sellerservicers to select a stated servicing fee that results in larger servicing assets and lower retained IO interests (or vice versa) with an eye to subsequent accounting. The potential accounting incentives for selecting a higher or lower stated servicing fee may counterbalance each other. On the other hand, because of potential earnings volatility (regardless of treatment), many issuers may look to ways to minimize servicing assets and sell or repackage servicing and IO strips. Again, note that the transfer of servicing is covered in EITF Issues No. 90-21 and 95-5, not FAS 166. Comparison of contractual servicing asset versus IO strip accounting under FAS 166 Servicing asset Definition IO strip The value of amounts above adequate Entitlements to interest spread beyond compensation that, per the contract, the contractually specified servicing rate is due to the servicer for servicing Fair value Fair value Trading: Marked-to-market (if interest income is required to be shown separately, use level yield prospective adjustment under EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets [325-40] see Chapter 9) or Available for sale: Level yield, prospective adjustment under EITF Issue No. 99-20 Fair value

Initially recorded at

Income recognition a. Measure servicing assets at fair value at each reporting date and report changes in fair value of servicing assets in earnings in the period in which the changes occur or b. Amortize in proportion to and over the period of estimated net servicing income and assess servicing assets for impairment based on comparison to fair value at each reporting date Balance sheet carrying value Consistent with initial election: either fair value or, for amortization method, initial fair value, less accumulated amortization and valuation allowance Not applicable for fair value method. For amortization method, through valuation allowance for an individual stratum when carrying amount exceeds fair value; change in valuation allowance in earnings

Recognition of impairment

Trading: Marked-to-market. Available for sale: Write-down to fair value under EITF Issue No. 99-20, if impaired, see Chapter 9

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Chapter 8 How do I measure and report fair value information?

FAS 157,9 sets out guidance on the measurement of fair value using the exit price notion and outlines the hierarchical disclosure requirements for investments measured at fair value. First, lets set the record straight: FAS 157 does not redefine fair value; rather it creates a uniform definition for the determination of fair value in GAAP through the concept of exit price. Through this uniform definition and the expanded disclosure requirements, FAS 157 emphasizes that fair value is a market-based measurement that is not entity specific. FAS 157s three-level disclosure hierarchy, which is described below, strives to bring increased transparency, consistency and comparability to fair value estimates. Consistency and comparability are clearly desirable in financial reporting; however, FAS 157s goals are squarely at odds with the wide range of valuation techniques in existence after the proliferation of securitization expanded the investor base. The struggle between these diverse valuation practices and FAS 157s desire for consistency and comparability is at the core of fair value controversies. No matter how complicated or detailed the technique or methodology, however, the end goal for accounting purposes remains the same: to derive an estimate of the price at which assets may be sold in the market at the valuation date. Do I need to measure the fair value of each position individually or can I use a portfolio approach? It depends. Sometimes, it shouldnt make much difference because the portfolio value will simply represent the sum of the values of the individual positions. In those cases, if it is just a matter of making the math easier, portfolio level valuation is fine. On the other end of the spectrum, using blockage factors is specifically prohibited; the fair value of a large position is the product of the price per unit (e.g., per share or dollars of par value) times the quantity of units held. [820-10-35-44] You also cannot use a portfolio approach to valuation to avoid recognizing other-than-temporary impairments in a portfolio that includes both winners and losers. Judgment is required when there is significant value created by the diversification inherent in a portfolio. For example, a portfolio of relatively illiquid bonds and related bespoke credit default swaps may be more valuable than the sum of the individual bonds and swaps valued separately. This would be true because it would be hard for a buyer of just one or two of the positions to duplicate that portfolio diversification themselves. Fair values are determined by the highest and best use in the most advantageous market. Accordingly, a portfolio valuation approach would be appropriate if potential buyers would be willing and able to acquire the portfolio intact. 1,2,3 ... What level to be? First, lets understand why the three-level hierarchy exists. The framework communicates the reliability of the inputs used to estimate fair value through the definition and prioritization of Level 1, Level 2, and
9

Chris Esposito

Statement of Financial Accounting Standards No. 157, Fair Value Measurements, codified as Topic 820.

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Level 3 inputs. When estimating fair value, investors are required to maximize the use of relevant observable inputs, using the following: Level 1: Quoted prices for the identical asset in an active market, without adjustment [820-10-35-40] Level 2: Anything that is not Level 1, but directly or indirectly observable, such as: Quoted prices for similar assets or liabilities in active or inactive markets Inputs other than quoted prices that are observable, such as yield curves, prepayment speeds, default rates, loss severities Inputs derived principally from, or corroborated by, observable market data [820-10-35-47 and 48] Level 3: Unobservable inputs that reflect the reporting entitys own assumptions about the assumptions market participants would use to estimate fair value. [820-10-35-52 and 53] One example of estimating fair value of beneficial interests issued in a securitization is a three-step present value technique that: creates the best estimate of cash flows generated from the assets applies the asset cash flows to the cash outflows per the transaction documents (i.e., the waterfall) discounts the cash flows for the securities held at the yield a buyer will demand Lets use this example to walk through some of the more daunting challenges investors face in estimating fair value. Is the market always right? What if it dries up? An investor will look to the markets to obtain observable information to be utilized in the fair value estimation process. But before arriving at the inputs for the valuation technique above, investors must evaluate the market so that they can make the appropriate judgments about the information being conveyed through various pricing signals. If an investor reaches a conclusion that there has been a significant decline in the volume or activity in a given market, further analysis of the transactions or quoted prices is needed and a significant adjustment to the transactions or quoted prices may be necessary to estimate fair value. Significant adjustments also may be necessary in other circumstances (for example, if a price for a similar asset requires significant adjustment to make it more comparable to the asset being measured or when the price is stale). [820-10-35-51B] To make a determination that a decrease in volume or level of activity has occurred, the investor needs to evaluate the following factors that are indicative of illiquid markets [820-10-35-51A]: There are few recent transactions Price quotations are not based on current information Price quotations vary substantially either over time or among market makers (for example, some brokered markets) Indices that previously were highly correlated with the fair values of the asset or liability are demonstrably uncorrelated with recent indications of fair value for that asset or liability There is a significant increase in implied liquidity risk premiums, yields, or performance indicators (such as delinquency rates or loss severities) for observed transactions or quoted prices when compared with the reporting entitys estimate of expected cash flows, considering all available market data about credit and other non-performance risk for the asset or liability
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 There is a wide bid-ask spread or significant increase in the bid-ask spread There is a significant decline or absence of a market for new issuances (that is, a primary market) for the asset or liability or similar assets or liabilities Little information is released publicly (for example, a principal-to-principal market) Together, an investors observations of information in the market and his judgments about the conditions of the market will drive the ultimate estimate of inputs to the present value technique described above. What is the best estimate of cash flows? How do I know whether my model of the structure is correct? What yield should I use to discount the cash flows? The answer to these questions will vary. As a general rule, the investor must answer these questions based on what a market participant would utilize and not his own view. Investors need not undertake all possible efforts to obtain information about market participant assumptions, but they need to incorporate information that is reasonably available without undue cost and effort. The continuing proliferation of detailed granular information on asset pools underlying securitizations results in an environment where the amount of information that might be considered in estimating the asset cash flows is often overwhelming. Consequently, there are sophisticated forecasting models that take into account factors, such as regional unemployment, home price appreciation (or depreciation), the length of time a court will take to liquidate a property in bankruptcy, the degree to which loan modification programs will take hold all in an effort to arrive at a forecast of securitization collateral cash flows to be applied to the structure. Further complicating the situation, most structures incorporate features that are difficult to model, may be highly subjective, and are legally untested. In certain cases, these features are major drivers of value, potentially rendering the first step of the process (asset cash flow estimation) of limited value. For example, many of the event of default and subordination provisions in CDOs challenge investors to conclude on interpretations of waterfalls described within transaction documents, often with very little or no precedent. Once an investor concludes he has the appropriate inputs to make an estimate of the asset cash flows, and that those cash flows are applied to the structure through an accurate model, the investor needs to determine the appropriate rate of return that a market participant would demand should some or any of the beneficial interests be sold. To that end, FASB Staff Position FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, provides an example of one technique a market participant might use to arrive at a market rate of return for an Alt-A backed security. In this example, a market participant begins with an observable risk-free rate, and then makes adjustments by adding or subtracting basis points for product type, length of time outstanding, market conditions at inception versus the valuation date, credit risk, liquidity risk, and other factors. The result is an estimate of a market rate of return that incorporates and quantifies adjustments based on other
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observable and unobservable factors. The example also highlights one way to incorporate the difference between the cash nature of the asset and the synthetic nature of an index as well as the difference between assets backing the security and those backing the index. Many of the adjustments are tied to concepts that highlight indicators for when a market has seen a decline in volume or activity. [820-10-65-4] Do I need to mark my book to indices? The creation of indices to track prices for securities at different levels of the capital stack for different products issued in certain vintages provides ever-increasing flexibility to investors in terms of hedging capabilities, speculation, and price discovery. Unfortunately, the indices only directly translate to fair value for the exact same portfolio of securities; consequently, adjustments are required in order to determine the fair value of a single security. Imagine trying to determine the value of ExxonMobil in the absence of an active stock market, with only the Dow Jones Industrial Average as a starting point, and you get the idea. Ultimately, one needs to determine whether the adjustments needed to indices in order to arrive at a market rate of return result in a more reliable estimate than the return one would estimate using another less discernible, but perhaps more relevant, variable. Can I book a gain or loss at inception? How do I calibrate my models? To the extent sale accounting is achieved, gains or losses from a securitization will arise for the seller when the fair value of the proceeds from the transaction is greater or less than the carrying amount of the assets and/or liabilities transferred. If the seller receives a beneficial interest in the transferred assets, care must be exercised in the estimation of fair value for those interests and strong support for any gain or loss recognition is required. The determination of fair value for beneficial interests received must adhere to the exit price notion called for in FAS 157, which recognizes the potential for transaction price to be different from exit price. In a speech in 2006, the SEC staff made it clear that models used to estimate fair value must be calibrated to reflect market conditions on the transaction date in a way that results in the exit price equaling transaction price, absent circumstances where the transaction price does not reflect fair value. Transaction price might not reflect fair value when the transaction is between related parties, when one or more of the parties is transacting under duress, or when the transaction price is established in a market that is not the principal or most advantageous market. What if I need to change valuation methods? What other information about fair value estimates should I disclose? Changes in valuation techniques or the application thereof could arise for a myriad of reasons. Techniques can be refined, or become less effective than alternatives, and markets could develop, consequently providing greater insight and stronger pricing signals, or they could diminish, leaving a dearth of pricing information. When changes occur, diligent consideration of the significance of valuation inputs must be given in order to appropriately classify the estimate in the fair value hierarchy. In accounting parlance, the change in valuation technique or its application is accounted for as a change in accounting estimate under 250-10-45-17 of Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections {par. 19}
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[250-10-45-17]. While FAS 154 has its own disclosure requirements, those criteria are not applicable because of existing fair value disclosures under FAS 157 (see What are the disclosure requirements? below for where changes in valuation techniques that result in a transfer in or out of Level 3 are disclosed). In any interim or annual period, reporting entities must discuss the valuation techniques used to measure fair value as well as any changes in the techniques and inputs used for each major security type. Examples of major security type could include: [942-320-50-2] Equity securities (segregated by industry type, company size, or investment objective) Debt securities issued by the U.S. Treasury and other U.S. government corporations and agencies Debt securities issued by states of the United States and political subdivisions of the states Debt securities issued by foreign governments Corporate debt securities Residential mortgage-backed securities Commercial mortgage-backed securities Collateralized debt obligations Other debt obligations What are the disclosure requirements? The disclosure requirements for recurring fair value measurements are as follows: a. The fair value measurement at the reporting date b. The level within the fair value hierarchy in which the fair value measurement falls, segregating the fair value measurement using quoted prices in active markets for identical assets or liabilities (Level 1), significant other observable inputs (Level 2), and significant unobservable inputs (Level 3) bb. The amount of significant transfers between Level 1 and Level 2, and the reasons for the transfers c. For fair value measurements using significant unobservable inputs (Level 3), a reconciliation of the beginning and ending balances, separately presenting changes during the period attributable to the following: 1) Total gains or losses for the period (realized and unrealized), segregating those gains or losses included in earnings (or changes in net assets) or recognized in OCI, and a description of where those gains or losses included in earnings (or changes in net assets) are reported in the statement of income (or activities) or in OCI 2) Purchases, sales, issuances, and settlements 3) Transfers in and/or out of Level 3 and the reasons for those transfers (for example, transfers due to changes in the observability of significant inputs) d. The amount of the total gains or losses for the period in subparagraph (c)(1) above included in earnings (or changes in net assets) that are attributable to the change in unrealized gains or losses relating to those assets and liabilities still held at the reporting date and a description of where those unrealized gains or losses are reported in the statement of income (or activities). An entity must also disclose the policy for recognizing timing of transfers.

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Chapter 9 What are some of the investor accounting issues?

How do I account for plain-vanilla MBS and ABS? All interests in securitized financial assets, whether purchased for cash or obtained (formerly known as retained) as consideration in a transfer accounted for as a sale, should be initially recorded at fair value. [860-20-30-1] The investor will need to make at least one and perhaps several accounting elections immediately upon recognizing its investment. The first accounting election is whether the investor wants to continue to report the interest at fair value on every subsequent balance sheet, thereby recognizing unrealized gains and losses due to fair value changes currently in earnings. This fair value option is available for most financial instruments, including securitized financial assets. [825-10-15-4] The election generally must be made on an item-byitem basis when each item is first recognized and for most practical purposes, is irrevocable once made. [825-10-25-2] The election is not, however, available as an alternative to consolidation for interests in VIEs. [825-10-15-5] If the investor decides not to use the fair value option, then the decision of what to do requires more thought. Most interests in securitized financial assets will meet the definition of a debt security. [320-10-20] Most importantly, for readers of this booklet, debt securities include all securitized debt instruments. Occasionally, transferors will structure a transaction so that they obtain financial interests that do not meet the definition of a debt security. Typically, this is done by leaving the transferors interests represented by contractual rights under the pooling and servicing agreement or other operative transfer document and not having them embodied in any book entry security or other instrument (i.e., leaving them uncertificated). Nonetheless, if such interests can be prepaid or otherwise contractually settled in such a way that the holder (e.g., transferor) would not recover substantially all of its recorded investment, those interests must be accounted for like a debt security and classified either as trading or available for sale. [860-20-35-3] An investor that did not avail themselves of the fair value option must elect to classify debt securities as either available for sale or held to maturity. [320-10-25-1] There is a third classification, trading, that is essentially similar to the fair value option.10 For the most part, this initial classification cannot be changed so long as the holder retains the security. Only transfers from the available-for-sale category to the held-tomaturity (HTM) category (but not vice versa) are readily permitted.

10

825-10-15-4 considerably expands the availability of fair value accounting to financial liabilities and financial assets other than securities. 320-10-25-1 allows for an initial election to classify debt securities as trading securities, even if the investor was not actively trading in the position.

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Trading securities are carried at fair value with unrealized gains and losses recognized currently in earnings. [320-10-35-1(a)] Securities that are acquired to be sold in the near term, and are, therefore, expected to be held only for a short period of time, must be classified as trading securities. An investor may also voluntarily designate other debt securities as trading securities. Available-for-sale securities are also carried at fair value on the balance sheet. However, changes in fair value are recognized on the balance sheet, net of tax effects, in a separate component of equity known as other comprehensive income (OCI) rather than in current earnings. [320-10-35-1(b)] If an individual securitys fair value declines below its amortized historical-cost basis and that decline is considered to be other-than-temporary, the security is impaired and some or all of the charge that would otherwise appear in OCI must be recognized as a loss in earnings. This establishes a new historical cost basis for the security, which means that any subsequent increase in fair value cannot be used to offset losses previously recognized. [320-10-35-17 through 34] The analysis of other-than-temporary impairments is further discussed below. HTM securities are carried at amortized historical cost basis, subject to write-downs for other-thantemporary impairments. In order to classify a security as HTM, the holder must have the positive intent and ability to hold the security until its maturity. [320-10-25-3] There are strict limits on the ability of an investor to sell HTM securities without impugning managements ability to claim the intent to hold other securities until they mature. [320-10-25-6] The permissible reasons to sell or reclassify HTM securities that are most frequently applicable to holders of ABS or MBS securities are [320-10-25-6]: Evidence of a significant deterioration in the issuers creditworthiness, such as a credit downgrade A significant increase in the holders regulatory capital requirement causing it to downsize its portfolio A significant increase in the risk-weights associated with the particular securities A sale near enough to contractual maturity so that interest rate risk is no longer a pricing factor (e.g., within three months of contractual maturity) Collecting a substantial portion (e.g., at least 85 percent) of the principal balance outstanding at the date the security was acquired, either due to prepayments or scheduled payments In contrast, sales or reclassifications due to changes in interest rates, prepayment rates, liquidity needs, alternative investment opportunities, funding or foreign currency exchange rates are not permissible reasons to sell a security classified as HTM. [320-10-25-5] The SEC staff has expressed the view that selling even one HTM security for an impermissible reason would call into question managements ability to make a credible assertion about the intent to hold other securities to maturity. In that case, the staff would expect all other HTM securities would be reclassified to available for sale and no new securities be classified as HTM for a period of two years. Securities that can be prepaid or otherwise contractually settled in such a way that the holder would not recover substantially all of its recorded investment may not be classified as HTM. Hedge accounting is not available for interest rate hedges of HTM securities. On the other hand, hedge accounting is permitted for interest rate hedges of the liabilities used to fund HTM securities. Also, HTM securities may be pledged as collateral in a financing transaction, including a securitization which does not qualify for sale treatment, without calling into question managements intent to hold the security to maturity.

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Do I have to worry about derivative accounting with MBS and ABS? The accounting definition of a derivative is quite broad and includes certain derivative characteristics embedded within so called hybrid instruments. [815-15 generally] Given the potential complexity of various interests in securitization transactions, it might seem obvious that many securitization interests would be considered hybrid instruments resulting in an accounting treatment that requires the embedded derivative to be split from the non-derivative host. To date, the FASB has provided exceptions for the most common approaches used in securitization transactions to allocate both prepayment and credit risk inherent in the underlying pool of financial assets. The FASB is currently working on an amendment to clarify and narrow the scope of this exception.11 Synthetic structures (e.g., those including credit default swaps) are the deals most likely to be impacted. The effective date is targeted for the first fiscal quarter beginning after June 15, 2010. The final guidance should be coming soon. Most existing positions would be potentially subject to the new rule. The most notable securitization interests subject to derivative accounting are inverse floaters, such as those issued as part of collateralized mortgage obligation structures.12 Investors may either elect the fair value option for these inverse floaters or bifurcate the embedded derivative from the host element and account for each separately. The embedded derivatives relate to the prepayment risk and to the inverse interest rate risk which would be combined and recorded as one instrument. How are discounts and premiums amortized? Frequently, the initial carrying value of an interest in a securitization will not be exactly par. Whether the difference is caused by market purchase premiums or discounts, investors need to use a rational and systematic method to recognize any difference in earnings over time. This is true even if the securities are being carried at fair value on the balance sheet (e.g., as trading securities or under the fair value option) so long as interest income appears as a separate line item on the investors income statement. When credit and prepayment risks are not substantial, the task is somewhat easier. Even so, most MBS and ABS will often have some actual prepayment experience that will need to be dealt with. One method is to simply amortize any premium or discount over the maximum contractual life of the position held. If prepayments cause the principal balance to decay more quickly, a portion of the unamortized amount would be recognized in earnings in order to catch up with actual prepayments. A second method is to begin amortizing any premium or discount based on an initial estimate of prepayments. That estimate is periodically revised as actual prepayments run faster or slower. In order to estimate prepayments, the underlying pool of assets needs to be large and composed of similar loans for which prepayments are probable and their amount and timing are subject to reasonable estimation. [310-20-35-26]

11 12

The primary guidance expected to change is 815-15-15-8 and 9 and the related examples from 815-15-55-222 to 226E.

See 815-15-25-34 {Issue B40 in the FASBs Derivatives (Statement 133) Implementation Issues}.

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Adjustable interest rates add an additional level of complexity. In addition to dealing with prepayments, the investor needs to deal with changes in the coupon interest rate over time. For interest rates indexed to LIBOR or some other market index or rate, the amortization schedule for the premium or discount can be established based on the projected cash flows using either the index or rate in effect at inception or it can be recalculated periodically as that index or rate changes over the life of the security. If there is an artificially high or low contractual rate in effect during the early periods, that would be leveled out over the life so long as the accreted balance does not rise to exceed the amount that would be immediately recognizable if the borrower elected to prepay (considering any applicable penalties). [310-20-35-18] The various level yield methods just mentioned do not cover securities and non-certificated interests that are of lower credit quality or could be contractually repaid in a way that the holder would recover less than substantially all of its initial investment, nor do they cover positions purchased after they have experienced significant credit deterioration. Read on for additional questions and answers covering those types of positions. When do I need to write-down underwater positions? Positions that have an other-than-temporary impairment (OTTI) will require a write-down of one sort or another. At every balance sheet date, the investor needs to identify individual security positions where the fair value is below the amortized cost, even if it is already carried at fair value as an available-forsale security. Once these impaired positions are identified, the next step is to determine whether the impairment is other-than-temporary (which does not mean permanent). Finally, the investor may need to estimate how much of the OTTI results from credit losses as compared to all other factors. For debt securities, such as securitization interests, OTTIs come in two basic varieties. If the investor either intends to sell a security or it is more likely than not that they will be required to sell it before it recovers (e.g., for regulatory reasons), then the investor must write down the security to its fair value. The writedown is charged to earnings. [320-10-35-34B] Thereafter, the investor accounts for the security as if it were purchased at fair value at the date of the write-down. Alternatively, if the investor does not intend to sell a security and it is more likely than not that they will not be required to sell it, the impairment may nonetheless be deemed other than temporary if the investor does not expect to recover the securitys entire amortized-cost through the present value13 of future expected cash flows. In that case, the write-down is split between the portion representing credit losses and the remainder related to all other factors. [320-10-35-34C] The entire write-down is shown in the earnings statement along with an offsetting amount to show the portion relating to all non-credit factors being moved to OCI. [320-10-45-8A] Thereafter, the amortized cost basis of the impaired positions is reduced by the credit impairment. Amounts included in other comprehensive income due to OTTI charges for HTM and available-for-sale securities should be shown separately. [320-10-45-9A]

13

This present value calculation would be based on the yield currently being used by the investor to recognize interest income on the security.

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What disclosures do I need to make when I dont write down my underwater positions? Both annual and interim financial statements should include [320-10-50-6]: As of each balance sheet date, a table, by category of investment, showing investments that have been continuously in a unrealized loss position for a year or more separately from those with unrealized losses for less than a year: The aggregate amount by which cost or amortized cost exceeds fair value The aggregate related fair value of investments with unrealized losses As of the most recent balance sheet date, a narrative discussion of the quantitative disclosures and the information that the investor considered (both positive and negative) to provide insight into the investors rationale for concluding that the impairments are not other-than-temporary. This discussion could include: The nature of the investment(s) The cause(s) of the impairment(s) The number of investment positions that are in an unrealized loss position The severity and duration of the impairment(s) Other evidence considered by the investor in reaching its conclusion that the investment is not other-than-temporarily impaired, including, for example, default and delinquency rates, LTV ratios, guarantees, subordination levels, vintage years, geographic concentrations, industry analyst reports, sector credit ratings, volatility of the securitys fair value, and/or any other information that the investor considers relevant How do I account for securities and other interests with significant prepayment and/or credit risk? IO strips, loans, or other receivables that can be contractually prepaid or otherwise settled in such a way that the holder would not recover substantially all of its investment are to be carried at fair value, similar to investments in debt securities classified as available for sale or trading. [320-30-25-5] This is true regardless of whether the asset was purchased or was obtained in a securitization and regardless of whether the asset (the entitlement to cash flows) is certificated as a security or uncertificated. No specific guidance precisely defines substantially all, but premiums of 10 percent or more warrant consideration. And, the probability of prepayment is not relevant in deciding whether this provision should apply. So the potential for the loss of a portion of the investment would not be evaluated differently for a wide-band PAC class versus a support class. EXAMPLE: You own a subordinated debt class from a securitization of mortgage loans. It has a principal amount and a variable rate of interest. Losses on the underlying mortgage loans in the pool are charged against this subordinated class before any losses are allocated to the senior classes. Because of this feature, the securitys fair value and carrying basis is significantly less than its principal amount. At inception, a certain amount of prepayments and losses is expected. At the end of the first quarter, (a) the actual interest rate on the class changes, (b) the actual prepayments and the estimate of future prepayments differ from the original expectation, and (c) the actual losses and the estimate of future losses differ from the original expectation. Your accounting method needs to be able to deal with all of these types of changes every period.

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The FASB has prescribed a particular prospective method for adjusting the level yield used to recognize interest income when estimates of future cash flows on the security either increase or decrease since the date of the last evaluation (typically quarterly). Securities covered include: All ABS, CDOs, CMBS, and MBS that are not (1) guaranteed by the government, its agencies or guarantors of similar credit quality or (2) sufficiently collateralized to ensure that the possibility of credit loss (whether of principal or interest) is remote. A minimum credit rating requirement (e.g., investment grade) to be eligible for exclusion from the provision is not specified; however, the SEC staff has set that threshold at AA client agency rating or equivalent. All IOs, including agency IOs and any other premium securities (regardless of rating), if prepayments could cause the holder not to recover substantially all of their recorded investment. Agency POs are excluded. The above securities are covered regardless of whether they are classified as HTM or available-for-sale. If classified as trading, they are already being marked to market, but the interest income recognition guidance applies if the holder is required to report interest income separately from unrealized gains and losses in their income statement. Securities designated as notes, bonds, pass-through, or participation certificates, and even trust certificates and CDO preference shares are typically covered because they often possess the characteristics of debt rather than equity securities. (see below) How do I compute periodic interest income when there is significant prepayment and/or credit risk or, whos afraid of 325-40, formerly known as EITF 99-20?14 Investors (as of the purchase date) and securitizers (as of the securitization settlement date) will need to estimate the timing and amount of all future cash inflows from the security using assumptions that were used in determining fair value. The excess of those future cash flows over the initial investment is the accretable yield to be recognized as interest income over the life of the investment using the effective yield method. As with any security, you determine the yield by solving for the internal rate of return (IRR) which equates those future cash flows back to the amount of the amortized cost of investment. At any balance sheet date, the amortized cost of the investment is equal to (1) the initial investment, plus (2) the yield accreted to date, less (3) all cash received to date regardless of whether labeled as interest or principal, less (4) any write-down for impairment (see below). You must update the cash flow estimates throughout the life of the investment taking into account the assumptions that marketplace participants would use in determining fair value. To determine the level yield used to accrete interest income in the following period, you must solve for a new IRR that equates the new estimates of future cash flow back to the amortized-cost amount at the latest balance sheet date. Some residual interests generate relatively small amounts of cash to the holder in the early periods of a securitization (due to the requirement to build up credit enhancement). When applying the effective yield method to these residuals, it is likely that the carrying value of the residual will be higher at the end of the year than at the beginning of the year and that is acceptable provided the estimates of cash flow are appropriate.
14

FASB Emerging Issue Task Force Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets

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Do I evaluate OTTI differently for securities with significant prepayment and/or credit risk? OTTI evaluations always need to consider whether the investor intends to sell a security before it recovers its value. Likewise, they need to consider whether it is more likely than not that the investor will be required to sell a security before recovery. When either of those conditions are present, the investor must write-down the security to its fair value and treat it as if it were newly purchased at that date and value. The biggest difference in evaluating OTTI for securities with significant prepayment and/or credit risk occurs when the investor does not intend to sell and it is more likely than not they wont be required to sell the security before it recovers its value back to the amortized-cost level. In that case, the method used to estimate the fair value of expected future cash flows is more specifically prescribed. For example, impairment determination should be based on the same forecast of future cash flows and the same IRR used to recognize periodic interest income as described above. And changes in cash flow resulting from resets on floating rate securities are not taken into account in this test provided the security is plain-vanilla, e.g., not a super-floater or an inverse floater. [325-40-35-9] Assuming that an OTTI exists, the same writedown method described above should be used to move the portion of the charge related to all non-credit factors from earnings to the other comprehensive income portion of equity. How about an example of interest recognition and impairment recognition for securities with significant prepayment and/or credit risk? Suppose you purchase a B-piece on January 1, 2010, for $106.08 (those days are gone but the concepts and mathematics described below will also work for deep discounts). It has a face amount of $100 and is also entitled to all of the excess interest from the net coupon on the loans over the interest paid to the senior class, subject to reimbursing the senior class for credit losses. You have the positive intent and ability to hold this security until maturity and have not elected to classify it as a trading security. The assumed pretax yield at the date of purchase is 10.77 percent per annum based on an assumed prepayment rate of 5 CPR and assumed losses of 100 basis points per annum on the outstanding principal amount of the loans (Base case). As of the end of year one, there are five alternative scenarios for the four years to follow presented in the following table. The first is that the base case prepayment, loss and market yield for the B-piece assumptions do not change. The other scenarios involve an increase or decrease in one or more of the assumptions as to prepayments, losses, and market yield for the B-piece.

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Sample EITF Issue No. 99-20 calculation Scenarios for years 2 through 5 Base case 1 2 3 4 5 6 7 8 9 10 11 12 13 Prepayment assumption Credit loss assumption Market yield for B-piece Cash flows to B-piece*: Year 1 Year 2 Year 3 Year 4 Year 5 Total years 1 through 5 Present value of year 2 thru 5 cash flows Fair value at end of year 1 (PV of lines 6 thru 9 discounted at market yield in line 3) Interest income for year 1 (investment of $106.08 times the base case yield of 10.77%) Preliminary amortized cost (initial investment, plus interest income less year 1 cash flow) Has there been a decrease in the present value of estimated remaining cash flows in line 11? Is fair value (line 12) below amortized cost (line 14)? Impairment to be recorded? (if line 15 and 16 are YES then line 14 minus line 12) Amount from line 17 moved to OCI (line 11 minus line 12) Balance sheet asset at end of year 1 Amortized cost basis at end of year 1 Revised yield for year 2 (IRR of lines 6 thru 9) Interest income for year 2 (line 19 times line 18) $101.80 $101.80 10.77% $10.96 $15.70 13.30 28.08 52.23 42.89 $152.20 $101.80 $101.80 $11.43 $15.70 11.19 31.70 49.24 38.52 $146.35 $97.75 $94.79 $11.43 $15.70 11.19 31.70 49.24 38.52 $146.35 $97.75 $104.94 $11.43 $15.70 14.34 24.51 54.44 46.65 $155.64 $103.96 $100.74 $11.43 $15.70 14.34 24.51 54.44 46.65 $155.64 $103.96 $111.80 $11.43 5 CPR 100 bp 10.77% A 7 CPR 200 bp 12% B 7 CPR 200 bp 8% C 3 CPR 50 bp 12% D 3 CPR 50 bp 8%

14

$101.80

$101.80

$101.80

$101.80

$101.80

15

NA

YES

YES

NO

NO

16 17 18 19 20 21 22
*

NO NO

YES $7.01 $2.96 $94.79 $97.75 10.77% $10.53

NO NO

YES NO

NO NO $101.80 $101.80 11.59% $11.80

$101.80 $101.80 $101.80 9.17% $9.34 $101.80 11.59% $11.80

For reverse-engineers only: The deal structure used to generate the cash flows going to the B-piece was a pool of five-year loans with a principal amount of $250 amortizing with five annual payments of $50. Gross coupon of 12 percent on the outstanding principal (after charge-offs) less servicing fee of 1 percent of the outstanding principal (before charge-offs). The senior class had a principal amount of $150, an interest rate of 6 percent and was entitled to 100 percent of all scheduled and unscheduled principal payments and liquidations until retired. If the B-piece had been classified as available-for-sale, the balance sheet asset amount would always be fair value as shown in line 12. In scenarios B, C, and D, the difference between fair value and amortized cost would be reflected as a debit or credit in OCI.

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What about whole loans and participating interests? Most securitizations transactions involve pools of loans. Some transferors have historically treated other uncertificated interests as still being a part of their loan portfolio. That practice will likely continue and even become more prevalent for retained participating interests. Because a participating interest is limited to essentially pro rata share of the cash flows, FAS 166s basis allocation process will result in a nearly pro rata basis allocation to the retained participating interest, further supporting the idea that a retained participating interest should continue to be reported as part of the loan portfolio. Loans may be classified as held for sale and carried at the LOCOM. [310-20-15-4] Premiums and discounts related to loans held for sale are not amortized [948-310-25-3] and no separate allowance for credit losses is provided it all just rolls up in the LOCOM valuation. Loans not classified as held for sale are classified as long-term investments and carried at amortized carrying amount, subject to allowances for credit losses and evaluation for impairment. Loans moved from the held for sale category to the long term investment category, are transferred at the lower of cost or market value. [948-310-30-4] Even if the retained participating interest continues to be a part of the loan portfolio, there is still a question as to whether the classification should be retained. Loans held for investment are not subject to the same provisions with respect to sales as those relating to securities held to maturity. While a regular pattern of sales would raise questions, an occasional well-intentioned sale would probably not be fatal to the accounting classification of the remaining loans. Loans moved from the available for sale category to the long term investment category are transferred at the lower of cost or market value. [948-310-30-4] When can I put my investments on non-accrual status? Investments may be put on nonaccrual status and may use the cost recovery method or the cash basis method of income recognition when investors are unable to develop a reasonable expectation when attempting to estimate the cash flows. [310-30-35-3] However, do not use the nonaccrual designation to circumvent the requirements to recognize OTTI.

80

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Chapter 10 Can banks get regulatory capital relief through securitization?

As it stands in January 2010, the answer to the question above is: Not so much. Generally, a bank15 must maintain total capital of at least 8 percent of its risk-weighted assets (10 percent for those who want to be considered well-capitalized banks). At least 4 percent (or 6 percent) of that capital is expected to be Tier-1 Capital. The remainder can be Tier-2 capital, up to an amount equal to Tier-1 capital. Regulators can also require additional capital on a case-by-case basis. Tier-1 Capital is comprised of common stockholders equity, noncumulative perpetual preferred stock, plus minority interest in subsidiaries, less most intangible assets as well as deductions for excess amounts of certain mortgage servicing assets, nonmortgage servicing assets, purchased credit card relationships, credit-enhancing interest-only strips (CEIOs), and deferred tax assets. Tier-2 Capital includes perpetual preferred stock and debt, mandatorily convertible securities, certain hybrid capital instruments, and subject to various limitations, allowance for loan and lease losses (ALLL), term preferred stock and subordinated debt, and unrealized holding gains on equity securities. The U.S. bank regulatory agencies risk-based measures (the general risk-based capital rules and the advanced approaches rules, collectively the risk-based capital rules) establish bank capital requirements intended to reflect the risks associated with on-balance sheet as well as off-balance sheet exposures, such as guarantees, commitments, and derivative transactions. The agencies use GAAP as the initial basis for determining exposures for riskbased capital purposes. Additionally, the agencies leverage measure (leverage rule) uses consolidated assets as the basis for setting the minimum capital requirements intended to limit how far a bank can leverage its equity capital base. So securitizations that are on balance sheet because of FAS 166 and 167 will also be included in the banks regulatory capital calculations. Banks may also need to establish an ALLL to cover estimated credit losses on the assets of consolidated VIEs. Consequently, absent a change in the capital rules (and all other factors remaining constant), both the leverage and risk-based capital ratios of banks are likely to fall by varying amounts as they bring back on balance sheet formerly off-balance sheet securitizations. The agencies have offered a transition option16 consisting of: 1) a two-quarter delay (exclusion period), through the end of the second quarter after the implementation date of FAS 166 and 167 of recognition of the effect on risk-weighted assets as well as on ALLL includable in Tier-2 capital that results from a banks adoption of FAS 167

15

We use the term bank generically. This chapter is also relevant to bank holding companies and thrifts. For example, Tier-1 Capital is called Core Capital by thrifts. See Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Regulatory Capital; Impact of Modifications to Generally Accepted Accounting Principles; Consolidation of Asset-Backed Commercial Paper Programs; and Other Related Issues, January 21, 2010.

16

Chapter 10

81

2) an additional phase-in for those banks that opt for the delay of those effects over the next two quarters (phase-in period). A bank that chooses to implement this transition mechanism must apply it to all relevant SPEs. The effect of these transition mechanisms on risk-based capital ratios would be reflected in the regulatory capital information reported for the four quarter-end regulatory report dates following the date the bank adopts FAS 166 and 167. For most banks, the adoption date will be January 1, 2010, allowing them to delay the regulatory capital effects until July 1, 2010, and then phase the effect in through December 31, 2010. The length of the transition provisions reflects the announced ending dates of the government programs supporting the securitization market, while allowing potential securitization reform initiatives to be extended through 2010. The delay and partial implementation periods also provide time for financial market participants and the agencies to observe the effects of these changes on bank lending, financial markets, and the overall economy. The transition mechanism is optional because it requires banks choosing the option to prepare and maintain two sets of financial records for affected VIEs for the duration of the delay and partial implementation periods. Accounting separately for financial reporting under GAAP and for regulatory capital reporting based on contractual exposure to VIEs is a requirement that banks in the past have asserted is unduly burdensome. Transition for risk-weighted assets During the two quarter exclusion period, a bank may choose to exclude from risk-weighted assets the effect of consolidated VIEs (including asset-backed commercial paper conduits the bank sponsors) provided that: the VIE existed prior to the banks implementation date and the bank did not consolidate the VIE on its balance sheet for quarter-end regulatory reporting dates prior to the implementation date (December 31, 2009, for most banks). A bank may not exclude the assets of any SPE where the bank has provided credit enhancement beyond actual contractual support obligations related to assets it previously sold (implicit support). During the exclusion period, the bank would continue to calculate risk-weighted assets for the excluded VIEs based on its contractual exposures to these VIEs, including direct-credit substitutes, recourse obligations, residual interests, liquidity facilities, and loans. Similarly, the agencies expect banks will use their December 31, 2009, methodology to calculate the risk-weights of exposures to excluded ABCP programs. During the phase-in period, a bank that has adopted the optional exclusion transition mechanism would include only 50 percent of its incremental risk-weighted assets. Regardless of any exclusion or phase-in election, banks must calculate risk-weighted assets at least equal to the amount based on contractual exposures had the VIEs not been consolidated. Transition for ALLL During the exclusion period, an electing bank may also include in Tier-2 capital the full amount of the ALLL attributable to the excluded assets. Normally, there is a limitation on ALLL of 1.25 percent of risk-weighted assets; for the excluded assets above, this limitation does not apply to the related ALLL. Following the model for risk-weighted assets, during the subsequent phase-in period, the ALLL related to the excluded
82 Securitization accounting

half of the SPE assets would be included in Tier-2 capital without limitation. The ALLL related to the 50 percent of the SPE assets included during the phase-in period, together with the ALLL related to assets not subject to the transition mechanism, may be included in Tier-2 capital subject to the normal limit 1.25 percent of riskweighted assets. As with the transition for risk-weighted assets, a bank may not adopt the transition mechanism for ALLL for new VIEs (that it must first consolidate after implementing FAS 167) or to which it has provided implicit support. Therefore, a bank may not include in regulatory capital ALLL amounts exceeding the 1.25 percent limit that is associated with assets of a VIE to which it has provided implicit support. What are the reg cap considerations for off-balance sheet securitization? Banks generally need to maintain risk-based capital equal to the face amount (defined below) of any on-balance sheet residual interest (net of any existing associated deferred tax liabilities) resulting from a securitization that qualifies for off-balance sheet accounting. It does not matter whether such amount is more or less than the risk-based capital requirement for the assets securitized. Thus, the capital requirement for residual interests can be less than the 8 percent of assets whenever the residual is less than 8 percent of assets. Some definitions are in order: A Residual interest means any on-balance sheet asset that represents a beneficial interest in a securitization accounted for as a sale and that exposes the bank to ANY credit risk directly or indirectly associated with the transferred asset that exceeds a pro rata share of that banks claim on the asset. Residual interests include CEIOs (see below), spread accounts, cash collateral accounts, retained subordinated interests, and other forms of over-collateralization. Residual interests generally do not include interests purchased from a third-party other than purchased CEIOs (defined below). A seconddollar or third-dollar loss position would be considered to expose the bank to more than a pro rata share of losses. If any other interests are senior to these forms of beneficial interests, the regulators would say the beneficial interest would be a residual interest; however, if rated, it might be eligible for more favorable capital treatment. Face amount means the amortized cost of an asset, if not held in a trading account (e.g., accounted for as HTM [if permitted] or available for sale) or the fair value of the asset if held in a trading account. Therefore, although the balance sheet carrying value of an available-for-sale asset might have been increased or decreased for unrealized appreciation or depreciation, it is the amortized cost amount that should be used in the calculation of risk-based capital. Deferred tax liabilities In order for deferred tax liabilities to reduce risk-based capital requirement, the liability must be on the balance sheet and specifically identifiable with a particular residual interest. For example, if a securitization was accounted for as a sale for GAAP but treated as debt for tax and gain on sale was recognized in an amount approximating the present value of a received IO strip, then it is likely that deferred taxes would have been provided on that timing difference, which will reverse over the life of the securitization. On the other hand, if the residual interest was represented by a deposit into a cash collateral account, it is unlikely that there would be any associated deferred taxes.
Chapter 10 83

Permitted reductions for rated received interests Certain rated received beneficial interests (with the exception of CEIOs) are not subjected to the full dollarfor-dollar capital treatment. The following table presents the manner in which the ratings-based approach would typically be applied, for example, to a second-dollar loss position. These same risk-weightings and capital requirements apply to a bank or thrift that invests in ABS, CDOs, CMBS, and MBS issued by others. Capital required for each $1 of investment1 Adequately Well capitalized capitalized 1.6 cents 4 cents 8 cents 16 cents 100 cents 2 cents 5 cents 10 cents 20 cents 100 cents

Example rating Investment grade: AAA or AA2 A2 BBB One category below: BB B and below, and all unrated
1

Risk-weight 20% 50% 100% 200% Up to dollar for dollar maximum3

The risk-weighting is applied against the book value of the investment (typically amortized cost) and not the face amount. The amounts shown as capital required assume an 8 percent required capital level. For example, $1 x 20% x 8% = $.016. IOs and POs, regardless of rating are not eligible for less than 100 percent weighting. These securities are not eligible for the risk-weighting approach. The capital requirement would be equal to the face amount of the security plus the pro rata portion of all the more senior positions it supports (that is, the institutions proportional ownership of the subordinated security multiplied by all of the more senior securities in the securitization) times 8 percent, but not greater than the amortized cost. Dollar-for-dollar treatment means, effectively, that one dollar in total risk-based capital must be held against every dollar of a security rated B and below, or unrated.

2 3

Keep in mind that a 200 percent risk weight is a lower capital charge than dollar for dollar. The capital requirement for a position is computed by multiplying the face amount of the position by the appropriate risk weight determined from the table. Thus, under the rule, securities rated BB require capital equal to 16 percent, which is 200 percent x 8 percent of the face amount, whereas, securities B and below or unrated require capital equal to 100 percent of the face amount (dollar-for-dollar capital). Only one rating is required if there is a reasonable expectation that in the near future, either the position may be traded or the position may be used in a secured loan or repo transaction in which a third-party relies on the rating. Otherwise, to qualify for the ratings-based approach, the position must be rated by more than one rating agency, the ratings must be the equivalent of BB or better by all rating agencies providing a rating, the ratings must be publicly available, and the ratings must be based on the same criteria used to rate securities that are traded. If the ratings are different, the lowest rating will determine the risk-weight. If a bank does not receive any residual interests but provides other forms of recourse on the transaction, then a credit-equivalent amount for the recourse obligation is computed. This is the full amount of the credit-enhanced assets for which the bank assumes credit risk, subject to a low-level exposure rule. Thus, a bank that extends a partial guarantee of, for example, the first 5 percent of loss on a securitization, must maintain capital equal to 5 percent of the transferred assets. If the guarantee covered the first 10 percent of loss, then the risk-based capital could be limited to 8 percent of the transferred assets. Examples of recourse include credit-enhancing reps and warranties, loan servicing arrangements where the bank is

84

Securitization accounting

responsible for losses, assets sold under an agreement to repurchase and credit derivative contracts under which the bank retains more than its pro rata share of credit risk on transferred assets. If a bank securitizes assets in a sale and provides credit enhancement in the form of both residual interests and other recourse obligations (e.g., writing a limited guarantee regarding the performance of the assets or entering into a credit derivative), then the capital is computed as the greater of the risk-based capital requirement for the residual interests or the full risk-based capital requirement for the transferred assets. If a bank sells a residual interest to a third party and writes a credit derivative to cover the credit risk associated with that asset, the selling bank must continue to risk-weight and maintain capital for that asset as a residual as if the asset had not been sold. The same holds true if a bank transfers the risk on a residual interest through guarantees or other credit risk mitigation techniques and then reassumes this risk in any form. Concentration limit for certain residual interests The rule imposes a concentration limit on CEIOs, whether received as proceeds or purchased, to 25 percent of Tier-1 capital as adjusted for any other disallowed items. For regulatory capital purposes only, any amount of CEIOs that exceeds the 25 percent limit will be deducted from Tier-1 capital. CEIOs that are not deducted from Tier-1 capital, along with all other residual interests, are subject to the dollar-for-dollar requirements, as described above. By way of definition, a CEIO means an on-balance sheet asset that represents the contractual right to receive some or all of the interest due on transferred assets and exposes the bank to credit risk that exceeds its pro rata claim on the underlying assets. Thus, CEIOs include any balance sheet asset that represents the contractual right to receive some or all of the remaining interest cash flow generated from assets that have been transferred to an SPE after taking into account trustee and other administrative expenses, interest payments to investors, servicing fees and reimbursements to investors for losses attributable to the beneficial interests they hold. An instrument with these characteristics will still be considered a CEIO, even if it is entitled to some principal. EXAMPLE: A bank has $100 in purchased and retained CEIOs on its balance sheet and Tier-1 capital of $320 (before any disallowed servicing assets, purchased credit card relationships, and deferred tax assets). The bank would multiply the Tier-1 capital of $320 by 25 percent, which is $80. The amount of CEIOs that exceed the concentration limit, in this case $20, is deducted from Tier-1 capital (with no corresponding add back to Tier-2 capital). The remaining $80 is then subject to the dollar-for-dollar capital charge. The $20 deducted from Tier-1 capital, plus the $80 in total risk-based capital required, equals $100, the balance sheet amount of the CEIOs. Banks may apply a net-of-tax approach on any CEIOs that have been disallowed from Tier-1, as well as to the remaining residual interests subject to the risk-based capital rule. Quarterly valuations The rule requires that the fair value of servicing assets, purchased credit card relationships, and CEIOs be updated at least quarterly and include adjustments for any significant changes in assumptions. The regulators may require independent fair value estimates where they deem it appropriate.
Chapter 10 85

Will transforming loans into securities reduce the required capital? Some banks might consider securitizing pools of whole loans and, if achieving sale accounting, receiving part of the beneficial interests as proceeds. Depending on the risk-weighting of the pool (first-lien one-tofour-family residential mortgage loans originated using prudent underwriting standards are risk-weighted at 50 percent, not 100 percent) and depending on how many securities rated A or better can be created, a bank might be able to reduce the overall capital requirements on the pool and increase liquidity. However, the bank will only be able to convert whole loans into securities on the balance sheet in a transaction that meets the criteria for sale accounting. Basel II In the United States, the Basel II advanced approach has been adopted but applies only to a small group of large, internationally active core banks that are currently proceeding through a multi-year transition period. Other U.S. banks, which currently remain subject to the Basel I capital framework, are expected ultimately to have the option of remaining within a modified Basel I regime, opting in to the Basel II advanced approach (with supervisory approval) or opting in to a yet-to-be-finalized Basel II standardized approach. The U.S. version of the Basel II standardized framework was proposed for public comment in July 2008, but no further action has yet been taken.17 The core banks that must apply the Basel II framework do so for determining regulatory capital required for exposures arising from securitizations or similar structures, and must do so starting in 2010 using a phased in approach discussed below. Basel II covers both on-balance sheet and off-balance sheet credit exposures arising from both traditional and synthetic securitizations. A wide spectrum of businesses can generate securitization exposures under the Basel II definition, particularly because a banks role in individual deal structures can vary substantially. These three institutional securitization roles include: The bank is acquiring a securitization exposure as an investing institution The bank is securitizing assets as an originating institution The bank is providing support in connection with an asset-backed commercial paper facility From BASEL II accord Since securitizations may be structured in many different ways, the capital treatment of a securitization exposure must be determined on the basis of its economic substance rather than its legal form. Similarly, supervisors will look to the economic substance of a transaction to determine whether it should be subject to the securitization framework for purposes of determining regulatory capital. An originating bank may exclude securitized exposures from the calculation of risk-weighted assets only if all of the following conditions have been met. Banks meeting these conditions must still hold regulatory capital against any securitization exposures they retain. Significant credit risk associated with the securitized exposures has been transferred to third parties.

17

For more information on the proposed standardized framework, see www.mayerbrown.com/publications/article.asp?id=5681&nid=6.

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Securitization accounting

 The transferor does not maintain effective or indirect control over the transferred exposures. The assets are legally isolated from the transferor in such a way (e.g., through the sale of assets or through subparticipation) that the exposures are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership. These conditions must be supported by an opinion provided by a qualified legal counsel. The transferor is deemed to have maintained effective control over the transferred credit risk exposures if it: (i) is able to repurchase from the transferee the previously transferred exposures in order to realize their benefits or (ii) is obligated to retain the risk of the transferred exposures. The transferors retention of servicing rights to the exposures will not necessarily constitute indirect control of the exposures. The securities issued are not obligations of the transferor. Thus, investors who purchase the securities only have claim to the underlying pool of exposures. The transferee is an SPE and the holders of the beneficial interests in that entity have the right to pledge or exchange them without restriction. Cleanup calls must not be greater than 10 percent, may not be mandatory but at the discretion of the originating bank, and may not be structured to avoid allocating losses to credit enhancements or to investors. The securitization does not contain clauses that (i) require the originating bank to alter systematically the underlying exposures such that the pools weighted-average credit quality is improved, unless this is achieved by selling assets to independent and unaffiliated third parties at market prices; (ii) allow for increases in a retained first loss position or credit enhancement provided by the originating bank after the transactions inception; or (iii) increase the yield payable to parties other than the originating bank, such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the underlying pool. An exposure must meet operational requisites in order to be classified as a securitization under Basel II. There must be at least two different stratified credit risk positions (i.e., credit tranches) where all or a portion of the underlying credit risk is transferred to one or more third parties. Performance of exposure is dependent solely on the performance of the underlying pool of assets. And substantially all of the underlying exposures must be financial exposures. It is important to note that the capital treatment of a securitization exposure must be determined on the basis of its economic substance rather than its legal form. Exposures that meet the classification criteria are subject to a hierarchy of approaches for regulatory capital requirement calculation. The four common approaches are: Ratings-Based Approach (RBA): Capital, under the RBA, is based on exposure amount and riskweights which are distinguished by external credit rating, granularity (number of assets in pool) and seniority of the exposure. RBA must be applied to securitization exposures that are externally rated. If a rating can be inferred from a tranche that is directly subordinate, RBA tables can be used. Internal-Assessments Approach (IAA): IAA allows the banks to use internal ratings in conjunction with the RBA tables for liquidity and credit facilities extended to eligible ABCP programs.

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 Supervisory-Formula Approach (SFA): The SFA is used to calculate the capital for securitization exposures when the RBA (including with inferred ratings) or IAA are not applicable. When applicable, the use of SFA provides a number of benefits for institutions which are able to comply with the calculation and reporting requirements, such as considerable capital relief when compared to dollarfor-dollar capital deduction for unrated securitization exposures and avoidance of significant costs and disclosure requirements associated with obtaining and maintaining ratings which would be used solely for regulatory capital purposes (e.g., for privately placed structured loan facilities). For institutions that need/choose to implement SFA there are several areas of focus including: (1) availability of underlying transaction data SFA requires very granular collateral details, which often arent a primary data requirement at the origination/structuring phase and consequently may not always be readily available for a given transaction, (2) ongoing third-party involvement the needs related to data gathering are onerous, especially for non-originated transactions where there is reliance on servicers/clients for up-to-date transaction data on an ongoing basis, and (3) derivation of risk parameters effort will be required to create an approach to determine the various risk parameters which are required for the underlying pool. These issues will be most prominent for securitization exposures which arent financed through conduits and wouldnt traditionally be externally rated; examples include structured lending facilities with small/medium sized businesses, structured guarantees provided to SPEs, etc. Full Capital Deduction: Securitization exposures, to which none of these approaches can be applied, must be deducted dollar for dollar. RBA must be applied to securitization exposures that are externally rated. If a rating can be inferred from a tranche that is directly subordinate, RBA tables can be used. As indicated above, when a bank qualifies for the RBA, it has one year of parallel run where it calculates RBA pursuant to both Basel I and II, but is bound by the requirements determined under Basel I. Subsequently, there are three phase in years where the bank must meet the higher of: 95 percent of Basel I and 100 percent of Basel II 90 percent of Basel I and 100 percent of Basel II 85 percent of Basel I and 100 percent of Basel II Alternatively, IAA is available to liquidity facilities and credit enhancements that banks extend to ABCP programs. Where an external or an inferred rating is not available, the SFA must be applied. If none of these approaches are applicable for eligible liquidity facilities, banks may apply the highest risk-weight based on the underlying pool on an exception basis.

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Securitization accounting

Chapter 11 How do securitizations fare under international accounting standards?

International securitization accounting IAS 39 and beyond In the first section of this book, we said that FAS 166 and 167 do not apply to companies that do not follow U.S. GAAP. The other major securitization accounting framework is IAS 3918 developed by the IASB. At the beginning of 2010, 116 countries either require or permit the use of IASB standards for publicly traded companies. This includes 27 member countries of the European Union where application of IASB standards is mandatory. Some other jurisdictions, including Australia, Hong Kong, New Zealand, the Philippines, and Singapore, have adopted standards that are largely identical in wording to IASB standards. In Canada, the changeover to IFRS for publicly accountable, profit-oriented enterprises is for interim and annual financial statements relating to fiscal years beginning on or after January 1, 2011.

18

International Accounting Standard 39, Financial Instruments: Recognition and Measurement (IAS 39), covers many other topics beyond securitization. This chapter deals only with those derecognition aspects of IAS 39 relevant to securitization, which date back to 2004. As discussed later in this chapter, the IASB is currently working on projects to substantially revamp international accounting standards relating to derecognition of financial assets and consolidation.

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The following table provides a quick comparison of the international and U.S. accounting standards for securitization transactions: Comparison of IFRS and GAAP Primary guidance Spelling Legal isolation of assets IAS 39 Securitisation Not required
a

FAS 166 & 167 Securitization Required Required

Transferee/Investors ability Not required to pledge or exchange Call options Cleanup calls Transferee put options Consolidation of SPEs

Borrowing to the extent Borrowing to the extent of the option, of the optionb for most types Borrowing to the extent Does not preclude 100% sale of the optionb Borrowing to the extent Still a sale provided true sale opinion is obtained of the optionb Usually, under SIC 12 Consolidation is required if one party has power to direct most significant activities and exposure to potentially significant losses or benefits

Ability to guarantee Ability to retain subordinated interest Ability to enter into a total return swap Ability to repurchase any individual loan Revolving structures

Borrowing to the extent Still a sale provided true sale opinion is obtained of the guaranteeb Borrowing to the extent of the subordinated amountb Borrowing Borrowing to the extent of repurchase option limitb Rarely achieve derecognition see 19c Participating interests must be essentially pro rata. Seller may hold junior interests issued by buyer of entire asset/pool May be a sale if legal isolation can be achieved 100% borrowing

OK

a b

Unless some, but not substantially all, of the risks and rewards are transferred. Then to derecognize, the entity must not retain control as evidenced by the transferee having the ability to sell the assets. Assuming some, but not substantially all, of the risks and rewards are transferred and control has been retained (i.e., the transferee cannot sell the asset)

Does IAS 39 use the same concept of transfer as FAS 166? No. Under FAS 166, any conveyance of a noncash financial asset by or to someone other than the issuer is a transfer. So FAS 166 transfers include pledging a bond as collateral for a borrowing. Under IAS 39, in order to meet the definition of a transfer, the transferor must either: Transfer the contractual rights to receive the cash flows of the financial asset; or Retain the contractual rights to receive the cash flows of the financial asset (the original asset) (for example, it retains servicing of the assets), but assumes a contractual obligation to pass through those cash flows to one or more entities (the eventual recipients) and all of the following conditions are met: [IAS 39 - 18]
90 Securitization accounting

a. The transferor has no obligation to pay amounts to the eventual recipients, unless it collects equivalent amounts from the original asset. Short-term advances by the entity with the right of full recovery of the amount lent, plus accrued interest at market rates do not violate this condition. b. The transferor is prohibited by the terms of the transfer contract from selling or pledging the original asset other than as security to the eventual recipients for the obligation to pay them cash flows. c. The transferor is obliged to remit any cash flows it collects on behalf of the eventual recipients without material delay. In addition, the transferor is not entitled to reinvest such cash flows, except for investments in cash or cash equivalents during the short settlement period from the collection date to the date of required remittance to the eventual recipients, and interest earned on such investments is passed to the eventual recipient. [IAS 39 - 19] If the arrangement fails to meet any of the conditions above, the transaction is not a transfer, meaning that the company must continue to recognize the asset in its entirety and records any proceeds received as a liability. The objective of prescribing these conditions to qualify as a transfer to be considered for derecognition is to distinguish pass-through arrangements in which the entity acts more as an agent of the eventual recipients of the cash flows than as an owner of the asset having both an asset and a liability. [IAS 39 - BC56] Condition (a) indicates that a transferor has no liability (because there is no present obligation to pay cash), and conditions (b) and (c) indicate that the transferor has no asset (because the transferor does not control the future economic benefits associated with the transferred asset). [IAS 39 - BC60] Practically no revolving structure will meet criteria (c) above. Although some argue that revolving structures result in the investors purchasing new assets with collection proceeds, those new assets would not be investments in cash or cash equivalents. Allowing the transferor (perhaps as servicer) to keep the float from temporary reinvestments will also disqualify a transaction as an IAS 39 transfer and therefore preclude any derecognition. Transferring the servicing and any other rights to receive cash flows directly from the assets to a third party might be one way that an originator could meet the criteria for a transfer using a revolving structure. An originator could also continue to service assets in a static pool securitization accounted for as a transfer under IAS 39, although the servicing agreement would need to meet criteria (a), (b), and (c), which is often not the case today. What is the basic IAS 39 framework for derecognition following a transfer? Whether a transfer qualifies for derecognition does not directly depend on whether the transfer is directly to investors in a single step or goes through an SPE that transfers assets or issues beneficial interests to investors. Securitizers first consolidate all subsidiaries according to other IASB guidance19 and then evaluate the transaction in its totality. Whether the transfer qualifies for full, partial or no derecognition will depend on the proportion of risk and rewards transferred to the investors compared to the amount retained by the transferor. 1) If substantially all the risks and rewards of ownership of the financial asset are transferred, the transferor derecognizes the financial asset and recognizes separately as assets or liabilities any rights and obligations created or retained in the transfer. 2) If substantially all the risks and rewards of ownership of the financial asset are retained (i.e., the transferor continues to absorb most of the likely variability in net cash flows), the transferor continues
19

See International Accounting Standards 27, Consolidated and Separate Financial Statements and the related interpretation SIC 12, Consolidation Special Purpose Entities. SIC 12 require companies to consolidate SPEs that they, in substance, control. Examples of when control may exist in substance include securitization SPEs where the company has a right to a majority of the benefits or majority of the residual ownership of the SPE.

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to recognize the financial asset and an associated liability for the proceeds.20 [IAS 39 - 20] 3) If neither the transferees nor the transferor have substantially all the risks and rewards of ownership (e.g., a significant amount, but not substantially all, of the risks and rewards have been passed), the transferor either a. Derecognizes the transferred assets as in (1) above, if the transferor has not retained control of the financial assets or b. Continues to recognize the financial assets only to the extent of its continuing involvement in them, if the transferor has retained control of them. [IAS 39 - 20] The transferor has retained control of a transferred asset unless the transferee has the practical ability to unilaterally sell it in its entirety to an unrelated third-party without imposing additional restrictions on that sale. [IAS 39 - 23] Most securitization transactions will result in the transferor passing less than substantially all of the risks and rewards and retaining control of the transferred assets, so understanding the continuing involvement concept will be key. See What if I have continuing involvement in the transferred assets?, below. IAS 39 accounting for transfers
Situation Substantially all risks transferred Accounting

Derecognize old assets Recognize any new assets/liabilities

More risk transferred to investors

Control passed transferee can unilaterally sell entire asset Transferred and retained risks are both less than substantially all Control retained

Recognize assets and liability up to continuing involvement level plus any retained interest

Substantially all risks retained

Recognize all assets, proceeds are liability

Do I look at the entire asset or just the transferred portion? That depends. A part of a financial asset is considered separately for derecognition only if it comprises: a. only specifically identified cash flows from a financial asset (or a group of similar financial assets) b. only a fully proportionate (pro rata) share of the cash flows from a financial asset (or a group of similar financial assets) or
20

If a transferred asset continues to be recognized, the asset and the associated liability shall not be offset. Similarly, the entity shall not offset any income arising from the transferred asset with any expense incurred on the associated liability [IAS 39 - 36]

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c. only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets). [IAS 39-16] EXAMPLE: If an entity transferred to a securitization trust all the principal and all but 1 percent of the interest flows from a pool of financial assets, and the interest strip was neither more senior nor subordinated in any way, the transferred interest receipts and all of the principal would be the financial asset for which the transfer of risks and rewards would be evaluated. On the other hand, if the 1 percent interest strip was subordinated for purposes of providing credit enhancement to the investors principal, then the entire asset (e.g., pool of loans) would be the financial asset for which the transfer of risks and rewards would be evaluated. These conclusions are not affected by whether the trust issued to outside investors various classes of beneficial interests to achieve credit or time tranching. How do I tell if I have transferred or retained substantially all of the risks and rewards? Compare the transferors exposure, before and after the transfer, to the variability in the amounts and timing of the net cash flows of the transferred asset. A transferor has retained substantially all the risks and rewards of ownership of a financial asset if its exposure to the variability in the present value of the future net cash flows from the financial asset does not change significantly as a result of the transfer. A transferor has passed substantially all the risks and rewards of ownership of a financial asset if its exposure to such variability is no longer significant in relation to the total variability in the present value of the future net cash flows associated with the financial asset. [IAS 39 - 21] Examples of transferring substantially all the risks and rewards of ownership include: Unconditionally selling a financial asset Selling a financial asset together with an option to repurchase the financial asset at its fair value at the time of repurchase Selling a financial asset together with a put or call option that is deeply out of the money (i.e., an option that is so far out of the money it is highly unlikely to go into the money before expiring). [IAS 39 - AG39] Examples of retaining substantially all the risks and rewards of ownership include: Selling and repurchasing the same financial asset where the repurchase price is a fixed price or the sale price plus a lenders return Lending securities Selling a financial asset together with a total return swap that transfers the market risk exposure back to the seller Selling a financial asset together with a deep in-the-money put or call option (i.e., an option that is so far in the money that it is highly unlikely to go out of the money before expiring) Selling short-term receivables with a guarantee to compensate the transferee for credit losses that are likely to occur. [IAS 39 - AG 40] How do I account for a transfer resulting in the complete derecognition of a financial asset (or part of a larger one)? If a transfer results in a financial asset being derecognized in its entirety, but the transferor obtains a new financial asset or assumes a new financial liability, or a servicing liability, the transferor recognizes those new assets, liabilities, or servicing at fair value and any resulting gain or loss is reflected in current earnings. [IAS 39 - 25] If the asset derecognized was previously part of a larger financial asset, the previous carrying
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amount of the larger asset is allocated between the part sold and the part retained based on their relative fair values at the transfer date. [IAS 39 - 27] How do I record a servicing asset or liability? If the transferor retains the right to service the derecognized financial asset, the transferor recognizes either a servicing asset or a servicing liability. A servicing liability is recognized at its fair value if the servicing fee represents less than adequate compensation for the servicing. A servicing asset is recognized if the fee exceeds the adequate compensation level. The initial recorded asset value is based on the relative fair value basis allocation described in the preceding paragraph. [IAS 39 - 24] What is the difference between an IO strip and a servicing asset? A transferor may retain the right to a part of the interest payments on transferred assets as compensation for servicing those assets. The part of the interest payments that the entity would give up upon termination or transfer of the servicing contract is allocated to the servicing asset or servicing liability. The part of the interest payments that the entity would not give up is an IO strip receivable. For example, if the entity would not give up any interest upon termination or transfer of the servicing contract, the entire interest spread is an IO strip receivable. The fair values of the servicing asset and IO strip receivable are used to allocate the carrying amount of the receivable between the part of the larger asset that is derecognized and the part that continues to be recognized. If there is no servicing fee specified or the fee to be received is not expected to compensate the entity adequately for performing the servicing, a liability for the servicing obligation is recognized at fair value. [IAS 39 - AG45] How is gain or loss on sale calculated? On derecognition of a financial asset in its entirety, the difference between: a. the carrying amount, and b. the sum of (i) the consideration received (including any new asset obtained, less any new liability assumed) and (ii) any cumulative gain or loss that had been recognized directly in equity is recognized in earnings currently. [IAS 39 - 26] If the transferred asset is part of a larger financial asset (e.g., when an entity transfers interest cash flows that are part of a debt instrument, and the part transferred qualifies for derecognition in its entirety), the previous carrying amount of the larger financial asset shall be allocated between the part that continues to be recognized and the part that is derecognized, based on the relative fair values of those parts on the date of the transfer. For this purpose, a retained servicing asset shall be treated as a part that continues to be recognized. The gain or loss on derecognition is the difference between: a. the carrying amount allocated to the part derecognized, and b. the sum of (i) the consideration received for the part derecognized (including any new asset obtained less any new liability assumed) and (ii) any cumulative gain or loss allocated to it that had been recognized directly in equity is recognized as a gain or loss in earnings of the period. A cumulative gain or loss that had been recognized in equity is allocated between the part that continues to be recognized and the part that is derecognized, based on the relative fair values of those parts. [IAS 39 - 27]

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Is there any guidance on estimating fair value? When a transferor allocates the previous carrying amount of a larger financial asset between the part that continues to be recognized and the part that is derecognized, the fair value of the part that continues to be recognized needs to be determined. When the entity has a history of selling parts similar to the part that continues to be recognized or other market transactions exist for such parts, recent prices of actual transactions provide the best estimate of its fair value. IAS 39 does not permit the recognition of a positive arbitrage that might result from a securitization execution versus a whole loan sale, whenever there are illiquid securities or other non-traded instruments retained by the transferor. When there are no price quotes or recent market transactions to support the fair value of the part that continues to be recognized, IAS 39 says that the best estimate of the fair value is the difference between the fair value of the larger financial asset as a whole and the consideration received from the transferee for the part that is derecognized. [IAS 39 - 28] So what if the transfer does not qualify for derecognition? If a transfer does not result in derecognition because the transferor has retained substantially all the risks and rewards of ownership of the transferred asset, the transferor continues to recognize the transferred asset in its entirety and records a financial liability for the consideration received. In subsequent periods, the transferor continues to recognize any income on the transferred asset and any expense incurred on the financial liability. [IAS 39 - 29] If a transferred asset continues to be recognized, the asset and the associated liability are not offset. Similarly, there is no offsetting of any income arising from the transferred asset against any expense incurred on the associated liability. [IAS 39 - 36] If the transferred asset is measured at amortized cost, the option in IAS 39 to designate a financial liability at fair value through profit or loss is not applicable to the associated liability. [IAS 39 - 35] To the extent that a transfer of a financial asset does not qualify for derecognition, the transferors contractual rights or obligations related to the transfer are not accounted for separately as derivatives if recognizing both the derivative and either the transferred asset or the liability arising from the transfer would result in recognizing the same rights or obligations twice. For example, a call option retained by the transferor may prevent a transfer of financial assets from being accounted for as a sale. In that case, the call option is not separately recognized as a derivative asset. [IAS 39 - AG49] Also, again to the extent that a transfer of a financial asset does not qualify for derecognition, the transferee does not recognize the transferred asset as its asset. The transferee derecognizes the cash or other consideration paid and recognizes a receivable from the transferor. If the transferor has both a right and an obligation to reacquire control of the entire transferred asset for a fixed amount (such as under a repurchase agreement), the transferee may account for its receivable as a loan or receivable. [IAS 39 - AG50] What if I have continuing involvement in the transferred assets? One aspect of IAS 39 that many people find quite confusing (and is sure to remain quite controversial) is the accounting for retained subordinated interests. If the transferor has transferred a substantial portion of the risks and rewards, but not substantially all of them, the transferor needs to account for its continuing involvement. The retained subordinated interests stay on balance sheet, as would be expected. However,
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the subordination effectively provides a credit guarantee for a portion of the interest sold to investors, which is considered a form of continuing involvement. This means that a portion of the investors interest (i.e., the senior interest) does not qualify for derecognition. Instead, an additional amount equal to the subordinated retained interest stays on balance sheet as loans and an associated amount received as sales proceeds, plus the fair value of the credit enhancement is recorded as a borrowing. The continued recognition of both the subordinated retained interest and the continuing involvement in the portion sold has been described by many as double-counting. The IASB debated this issue and determined that it would have had to create an exception to its continuing involvement model for subordinated retained interests if it wanted to avoid this result. It decided not to create an exception. Paragraph AG 52 in IAS 39 shows a numerical example of this phenomenon. See Do I need to do any particular calculations of the risks and rewards transferred and retained? below. If a transferor transfers some but not substantially all the risks and rewards of ownership of a transferred asset, and retains control of the transferred asset, the transferor continues to recognize the transferred asset to the extent of its continuing involvement. The extent of the transferors continuing involvement in the transferred asset is the extent to which it is exposed to changes in the value of the transferred asset. For example: a. When the transferors continuing involvement takes the form of guaranteeing the transferred asset, the extent of the transferors continuing involvement is the lower of (i) the amount of the asset and (ii) the maximum amount of the consideration received that the transferor could be required to repay (the guarantee amount). b. When the transferors continuing involvement takes the form of a written or purchased option (or both) on the transferred asset, the extent of the transferors continuing involvement is the amount of the transferred asset that the transferor may repurchase. However, in case of a written put option on an asset that is measured at fair value, the extent of the transferors continuing involvement is limited to the lower of the fair value of the transferred asset and the option exercise price. These provisions apply to both cash-settled and physically-settled arrangements. [IAS 39 - 30] When a transferor continues to recognize an asset to the extent of its continuing involvement, the transferor also recognizes an associated liability. Irrespective of the other measurement requirements in IAS 39, the transferred asset and the associated liability are measured on a basis that reflects the rights and obligations that the transferor has retained. The associated liability is measured in such a way that the net carrying amount of the transferred asset and the associated liability is: a. the amortized cost of the rights and obligations retained by the transferor, if the transferred asset is measured at amortized cost b. equal to the fair value of the rights and obligations retained by the transferor when measured on a standalone basis, if the transferred asset is measured at fair value. [IAS 39 - 31] This approach is intended to result in the asset and the associated liability being measured in a way that ensures that any changes in value of the transferred asset that are not attributed to the transferor are not recognized by the transferor. [IAS 39 - BC68] If a guarantee provided by a transferor to pay for default losses on a transferred asset prevents the transferred asset from being derecognized to the extent of the continuing involvement, the transferred asset at the date of the transfer is measured at the lower of the carrying amount of the asset and the
96 Securitization accounting

guarantee amount. The associated liability is initially measured at the guarantee amount, plus the fair value of the guarantee (which is normally the consideration received for the guarantee). Subsequently, the initial fair value of the guarantee is recognized in profit or loss on a time-proportion basis and the carrying value of the asset is reduced by any impairment losses. [IAS 39 - AG48 (a)] The transferor continues to recognize any income arising on the transferred asset to the extent of its continuing involvement and shall recognize any expense incurred on the associated liability. [IAS 39 - 32] If a transferors continuing involvement is in only a part of a financial asset (e.g., when a transferor retains an option to repurchase part of a transferred asset, or retains a residual interest that does not result in the retention of substantially all the risks and rewards of ownership and the transferor retains control), the transferor allocates the previous carrying amount of the financial asset between the part it continues to recognize under continuing involvement, and the part it no longer recognizes on the basis of the relative fair values of those parts on the date of the transfer. For this purpose, the requirements of paragraph 28 of IAS 39 apply. The difference between: a. the carrying amount allocated to the part that is no longer recognized, and b. the sum of (i) the consideration received for the part no longer recognized and (ii) any cumulative gain or loss allocated to it that had been recognized directly in equity, is recognized as profit or loss currently. A cumulative gain or loss that had been recognized in equity is allocated between the part that continues to be recognized and the part that is no longer recognized on the basis of the relative fair values of those parts. [IAS 39 - 34] What are some common forms of continuing involvement? ROAPs and cleanup calls. The servicer of transferred assets, which may be the transferor, may hold either of two types of options to reclaim previously transferred assets. A ROAP is an option to repurchase assets, usually subject to certain limitations on how the particular assets are selected for call, how frequently and in what total amount the call can be exercised. A cleanup call is an option to purchase remaining transferred assets when the amount of outstanding assets falls to a specified level at which the cost of servicing those assets becomes burdensome in relation to the benefits of servicing. Provided that such a ROAP or cleanup call results in the transferor neither retaining nor transferring substantially all the risks and rewards of ownership and the transferee cannot sell the assets, it precludes derecognition only to the extent of the amount of the assets that is subject to the call option. [IAS 39 - AG51 (l) and (m)] Amortizing interest rate swaps. A transferor may transfer to a transferee a fixed rate financial asset that is paid off over time, and enter into an amortizing interest rate swap with the transferee to receive a fixed interest rate and pay a variable interest rate based on a notional amount. If the notional amount of the swap amortizes so that it equals the principal amount of the transferred financial asset outstanding at any point in time, the swap would generally result in the transferor retaining substantial prepayment risk, in which case the transferor either continues to recognize the entire transferred asset or continues to recognize the transferred asset to the extent of its continuing involvement. Conversely, if the amortization of the notional amount of the swap is not linked to the principal amount outstanding of the transferred asset, such a swap would not result in the transferor retaining prepayment risk on the asset. Hence, it would not preclude derecognition of the transferred asset provided the payments on the swap are not conditional on interest payments being made on the transferred asset and the swap does not result in the transferor retaining any other significant risks and rewards of ownership on the transferred asset. [IAS 39 - AG51 (q)]
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Subordinated retained interests and credit guarantees. The transferor may provide the transferee with credit enhancement by subordinating some or all of its interest retained in the transferred asset. Alternatively, the transferor may provide the transferee with credit enhancement in the form of a credit guarantee that could be unlimited or limited to a specified amount. If the transferor retains substantially all the risks and rewards of ownership of the transferred asset, the asset continues to be recognized in its entirety. If the transferor retains some, but not substantially all, of the risks and rewards of ownership and has retained control, derecognition is precluded to the extent of the amount of cash or other assets that the transferor could be required to pay. [IAS 39 - AG51 (n)] Do I need to do any particular calculations of the risks and rewards transferred and retained? Often it will be obvious, from the structure of the transaction or the pricing of the interests sold, whether the transferor has transferred substantially all risks and rewards of ownership or retained substantially all risks and rewards, and there will be no need to perform any computations. In other cases, it will be necessary to compute and compare the entitys exposure to the variability in the present value of the future net cash flows before and after the transfer. The computation and comparison is made using as the discount rate an appropriate current market interest rate. All reasonably possible variability in net cash flows is considered, with greater weight being given to those outcomes that are more likely to occur. [IAS 39 - 22] This guidance is reminiscent of the principles in FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities (revised December 2003) an interpretation of ARB No. 51 (FIN 46R). However, the IASB did not specify what statistic (e.g., standard deviation, variance, or mean absolute deviation as in FIN 46R) should be used to measure variability. The IASB did provide a numerical example to illustrate the application of the continuing involvement approach in paragraph AG52 of IAS39. That example assumes, but does not demonstrate, the conclusion that the transferor has passed some significant risk and rewards of ownership of the transferred assets (e.g., prepayment risk) while continuing to retain some significant risks and rewards (e.g., credit risk). The worksheet below shows one method, based on the standard deviation statistic,21 which might be used when calculations are required. The calculations require information about various possible future scenarios that is not included in the IAS 39 example, so hypothetical examples are used, while trying to fit as closely as possible to what information was given in AG52. In real life, you would probably need more than four scenarios, which should be based on real, supportable expectations and experience. With that said, the assumed scenarios are as follows: SCENARIO 1: PREPAY IMMEDIATELY All loans prepay all outstanding principal of $10,000 immediately after the closing of the securitization. There are no defaults and no interest has accrued since the closing date. Probability = 20% SCENARIO 2: PREPAY IN ONE YEAR All loans prepay all outstanding principal and accrued interest of $1,000 on the coupon payment date, which is the first anniversary of the securitization closing. There are no defaults. Probability = 30% SCENARIO 3: MATURE IN TWO YEARS All loans run to their contractual maturity at the end of two years. They pay timely the $1,000 coupon interest payment due on the first anniversary of the
21

Other risk measures could also be used. For example, FIN 46R bases its risk measurements on a variation of the mean absolute deviation statistic. IAS 39 does not specify any particular statistical concept to measure risk. We chose standard deviation for this example because it is a common risk measure and can be easier to work with, in a mathematical sense, in some circumstances.

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securitization closing and all outstanding principal and accrued interest of $1,000 on the maturity date, which is the second anniversary of the securitization closing. There are no defaults. Probability = 30% SCENARIO 4: DEFAULT IN ONE YEAR All loans default on all outstanding principal and accrued interest on the coupon payment date, which is the first anniversary of the securitization closing. Through immediate foreclosure and sale of the collateral properties, a total of $10,746 is recovered and applied to repay principal and accrued interest, first to the senior bond, then the subordinated bond. No recovery proceeds are available to the IO strip. Probability = 20% IAS 39 does not differentiate in regard to how the risk is allocated among the transferees. Similarly, IAS 39 does not care how or in how many tranches the transferors risk is retained. Therefore, the analysis can be simplified by dividing the asset cash flows for each scenario into two buckets the total amount due to the transferor and everything else, which represents the net amount due to all the transferees taken as a group. That method is illustrated in the table below. Probability weighted present value (using 8.5% risk-free discount rate)22 Scenario 1 2 3 4 Total Probability 20% 30% 30% 20% Total loans $ 2,000 3,041 3,079 1,980 $10,100 Transferredsenior $1,800 2,725 2,747 1,817 $9,089
23

Retainedsubordinate & IO $ 200 316 332 163 $1,011 Retainedsubordinate & IO 24 538 2,746 7,683 10,991 $104.84

Probability weighted squared deviations Scenario 1 2 3 4 Variance standard deviation (square root of Variance) Probability 20% 30% 30% 20% Total loans 2,000 403 8,003 8,000 18,406 $135.67 Transferredsenior 1,584 10 1,374 3 2,971 $54.51

Notice that the sum of the standard deviations of the transferred senior portion and the retained subordinated and IO portions add up to more than the standard deviation of the loans as a single portfolio. Try to visualize this effect with the following picture of a triangle. We use arrows for the sides of the triangle, because risk has a direction associated with it (e.g., a long or short position). The diagram
22

For example, under Scenario 2, the loan pays a total of $11,000 one year from today. Of that amount, $9,855 is paid to the senior interests and $1,145 is retained by the subordinated interests. The present values of those amounts, discounted for one year at 8.5 percent, are $10,138, $9,083, and $1,055, respectively. Weighting each by the 30 percent probability assigned to Scenario 2 gives us $3,041, $2,725, and $316, respectively. 23 For example, the deviation of the total loan amount in Scenario 1 from the overall average is the difference between $10,000 and $10,100, which equals $100. Squaring that deviation gets us to 10,000 and weighting it by the 20 percent probability of Scenario1 yields 2,000.

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s Tran

fere

$5 es =

4.51

Trans fe

ror = $

104.8

Portfolio = $135.67

shows that in total, we start at the same beginning spot and arrive at the same end point before and after the transaction. The paths are simply different.

One way to evaluate the amount of risk transferred would be to sum up the total risk exposure of the transferor after the transaction and the net risk exposure of the transferees as a group to create a new, larger denominator. Then you could divide the transferors total risk after the transaction by that sum. But IAS 39 cares about the proportion of the risk of ownership of the assets that has been transferred or retained, not the absolute amount of risk exposure of the transferor or transferee. This distinction is important, because risk does not add or subtract in simple, mathematical ways. The portfolio diversification effect of the loans as a Trans group reduced the total risk of the portfolio to feror total = $10 something less than the arithmetic sum of the 4.84 Side risks of each loan. The subordination structure bet of the transaction acts in a similar fashion, but Assets risk retained in the opposite direction. Rather than reducing 1 .5 $54 t= risk through diversification, it increases risk by Side s ne e fere bet introducing to both the transferor and transferees rans T as a group an equal and offsetting new risk that Assets risk transferred is completely uncorrelated with the aggregate asset portfolio risk. In essence, the transferor and transferee have made a small side bet using a portion of the asset portfolio as the amount of the wager. Visualize this by breaking the previous diagram into two parts. Again, each diagram shows the same beginning and end to represent the total risk to the transferor and the net risk to the transferees as a group. It also reveals the portion of the risk of the assets retained and transferred. If we knew how the asset portfolio risk correlated with the total risk to the transferor or the net risk to the transferees as a group, it would be a simple matter to measure the numerical amount of the asset risk retained and transferred. The calculations of all the required correlations (statistics) would quickly become tedious, however. Fortunately, some high school trigonometry allows us to use the previously calculated variance statistics to compute24 the percentage of risk transferred (28 percent) and the percentage of risk retained (72 percent). IAS 39 does not establish any bright-line guidance on the cutoff levels for what represents substantially all. If the transferor had adopted something in the 80 percent to 90 percent range as their level for substantially all, then in this hypothetical case, the conclusion would be that the transferor had neither transferred substantially all of the portfolio risk nor retained substantially all of it.
24

The formulas work out to: Risk Transfer % 50% + [Var(Transferred) - Var(Retained)] [2Var(Portfolio)] = = 50% + [2,971 - 10,991] [218,406] = .5 - (8,020 36,812) = 28% Risk Retention % = 50% + [Var(Retained) - Var(Transferred)] [2Var(Portfolio)] = 50% + [10,991 - 2,971] [218,406] = .5 + (8,020 36,812) = 72%

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What changes are on the horizon for International Accounting Standards? The IASB is working towards revamping guidance on both of the two major securitization accounting issues consolidation and derecognition. These changes are likely to have a major impact on U.S. securitization accounting as well. Even though the SEC has not published an updated roadmap for allowing U.S. registrants to use international accounting standards for securities filings, the FASB has committed to join with the IASB to develop standards that are as consistent as possible. Currently, the IASB is finalizing its standard on consolidation. IASBs approach is broadly similar to the FAS 167 approach by considering both control and financial interest elements. There are a couple of notable differences, however. The IASB standard will not limit itself to structured finance vehicles (or SPEs, VIEs, or any other name you might choose). Instead, it will address the full range of potential subsidiary company situations. The IASB also has a slightly different idea about what constitutes control, particularly when kick-out rights are involved. The FASB is also expected to issue an Exposure Draft of an amendment to FAS 167 that will propose conforming the U.S. consolidation guidance to the IASB standard. Look for that as vacation reading for summer 2010. The IASB plans to issue its final standard during the third quarter of 2010 after they have seen the public comments on the FASB draft. Smart money bets on an effective date in 2013. The IASB had an interesting experience in its project on derecognition principles. In March 2009, the IASB issued an Exposure Draft suggesting changes to the current IAS 39 framework described above. In response, almost nobody (well, only 13 percent) of the comment writers favored their proposal. The status quo polled better at 23 percent. The majority of respondents favored an alternative approach contained in a short appendix explaining why five IASB members voted against the Exposure Draft to begin with. The IASB cares more about the quality of the ideas expressed in comments rather than just the quantity of cards and letters it gets. In this case, the tide of constituent opinion carried with it many valid objections to the proposed approach and many thoughtful reasons supporting the alternative views. So the IASB decided to regroup and adopt the alternative view going forward. Now the IASB plans to develop a derecognition standard based on control that differentiates between transfers where the transferor retains a proportional versus disproportional share of the transferred asset. If the retained interest is disproportionate then the transferred asset is fully derecognized and a new asset is measured at fair value. If the retained interest is proportional then the transferor will treat the retained interest as part of the transferred asset and therefore will derecognize only the part not retained. There are still details to be worked out by the IASB, including things like making sure everybody agrees on how to identify, describe, and value the new assets and liabilities. Some constituents may also not be happy with how this approach treats repo and securities lending transactions. For these reasons, it would not be surprising for the IASB to issue another Exposure Draft, even though it might not technically be required by their due process protocols. Another public comment process would also offer the FASB an opportunity to coordinate consideration of parallel changes to U.S. guidance. If done expeditiously, there would probably be time to produce a final derecognition standard that could be implemented in 2013 in conjunction with a revised consolidation standard. As with all forecasts, only time will tell, and your mileage may vary.
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Chapter 12 So where is the transparency?

There is probably uniform agreement among those involved with securitization that, especially in the wake of the turmoil in the financial markets, investors will continue to demand greater transparency in securitization. The FASB certainly recognized that concern by accelerating the issuance of guidance with respect to disclosures from the issuance of FAS 166 and 167 themselves; while the requirements of FAS 166 and 167 were still being debated, the FASB promulgated expanded disclosure rules, and then included them in the final statements. It is fair to say that the new disclosures expand upon the requirements that existed under previous guidance, and, with respect to FAS 167, introduce new disclosures not previously required. FAS 166 rules of the road A transferor of financial assets into a securitization should be attuned to the following objectives of the disclosure requirements under FAS 166: A transferors continuing involvement with financial assets previously transferred Information about any restrictions on assets included in the balance sheet of the reporting entity relating to transferred financial assets, including their carrying amounts The reporting of servicing assets and servicing liabilities For those transfers accounted for as either (1) sales where the transferor has continuing involvement or (2) secured borrowings, how the transfer impacts each of the transferors financial statements. [860-10-50-3] There are increased disclosure expectations pertaining to the need for enhanced qualitative information concerning any risk related to a transferors exposure from transferred financial assets and any restrictions on the transferred assets. Transferors are allowed discretion in preparing the disclosures with respect to presenting information at an aggregated level; as always, the preparer should present information in the footnotes to maximize usefulness. If aggregated reporting is utilized, then the transferor should disclose how similar transfers are aggregated, and clearly distinguish between transfers accounted for as sales and those accounted for as secured borrowings. [860-10-50-4A] When determining if aggregation is appropriate, information about the characteristics of the transfer should be considered including: the nature of any continuing involvement, the types of financial assets transferred, any risks to which the transferor continues to be exposed after the transfer, and the requirements of 825-10-55-1 {FASB Staff Position SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk}.

David Elizandro

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As previously discussed, the transferor must find the right balance between obscuring critical information as a result of too much aggregation versus providing excessive detail that makes it difficult to understand the risks and rewards to which the transferor is exposed. What if I have a secured borrowing? Should your transaction be accounted for as a secured borrowing, it could either be as a result of the failure to achieve non-consolidation of the VIE, or a failure to relinquish effective control. The objectives of disclosures under FAS 167 are to provide the financial statement users with the following information: a. The significant judgments and assumptions made by a securitizer in determining whether it must consolidate a VIE and/or disclose information about its involvement with a VIE b. The nature of restrictions on a consolidated VIEs assets and on the settlement of its liabilities reported by the securitizer in its balance sheet, including the carrying amounts of such assets and liabilities c. The nature of, and changes in, the risks associated with the securitizers involvement with the VIE d. How a securitizers involvement with the VIE affects the securitizers financial position, financial performance, and cash flows. [810-10-50-2AA] The requirements are clear that to the extent needed to achieve those objectives, depending on the facts and circumstances surrounding the VIE and the securitizers interest in that entity, the information may also be aggregated by similar entities to the extent that separate reporting would not provide more useful information. [810-10-50-9] Thus, a securitizer with multiple RMBS transactions that need to be consolidated may aggregate the information to the degree that disaggregation does not improve the disclosure so, for example, term transactions of prime loans versus subprime loans, subprime loans of different vintage, etc. Securitizers should consider both qualitative and quantitative information about the differing risk characteristics of the VIEs, as well as the significance of the VIE to the securitizer, in determining the appropriate level of aggregation. Differentiation should be made between those VIEs which are consolidated and those that are not but in which the securitizer has a variable interest. Additionally, the disclosure requirements under FAS 167 can be provided within more than one footnote of the financial statements so long as there is appropriate cross referencing between the various footnotes. [810-10-50-2AC] Now, for the requirements Whether you are the primary beneficiary, and thus must consolidate the VIE, or even if you just have a variable interest in a VIE, you must disclose: the methodology for determining whether you are a primary beneficiary of the VIE, including significant judgments and assumptions made in reaching that conclusion if the facts and circumstances have changed leading to a change in the previously reached consolidation conclusion, the securitizer is required to disclose the primary factors that caused the change and the consequent impact on the financial statements if, during the period covered by the financial statements, the securitizer has provided any financial or other support to the VIE that was not contractually required, including through implicit arrangements, or if the securitzer intends to provide such support, they should disclose information regarding the type and amount of support provided and the primary reasons the support was provided. [810-10-50-5A]
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Additionally, the securitizer should provide qualitative and quantitative information about involvement with the VIE, including the nature, purpose, size, activities, and financing of the VIE. [810-10-50-5A] If the securitizer is also the primary beneficiary, it should disclose: the gain or loss recognized upon initial consolidation of the vehicle the carrying amounts and classifications of the VIEs assets and liabilities, including information regarding the relationships between those assets and liabilities. For example, if the assets may only be used to settle specific liabilities, that relationship should be disclosed. when the VIEs creditors or the beneficial interest holders do not have recourse to the general credit of the reporting entity the terms of any explicit or implicit arrangements that could require the reporting entity to provide financial support to the SPE, including events or circumstances with the potential for the securitizer to incur a risk of loss [810-10-50-3] What about those variable interest holders who are not the consolidator? FAS 167 also requires specific disclosure requirements for those reporting entities that hold a variable interest in a VIE, but are not the primary beneficiary. In these circumstances, the disclosures include the carrying amount and classification of the assets and liabilities within the balance sheet associated with the variable interest in the VIE, and the maximum exposure to loss from involvement with the VIE. Qualitative information about how this amount was determined and the significant sources of exposure to the VIE, or if the amount cannot be quantified, need also be disclosed. [810-10-50-4] Information with respect to the carrying amount of the assets and liabilities and the securitization partys exposure to loss should be presented in a tabular format. Both qualitative and quantitative information to provide a sufficient understanding of the differences between the two amounts should also be provided, including the terms of arrangements (both explicit and implicit), potentially requiring the variable interest holder to provide additional financial support. Finally, the transaction party should also provide information about any support committed by third parties, including liquidity arrangements, guarantees, or other commitments. [810-10-50-4] Importantly, if the party to the transaction has not been identified as the primary beneficiary because of the existence of a shared power arrangement, they should disclose the significant factors they considered and judgments they made in determining that conclusion. [810-10-50-4] To the degree not disclosed already (for example, as just discussed), for transfers of financial assets accounted for as secured borrowings, the securitizer should disclose the carrying amounts and classifications of both assets and liabilities recognized within the transferors balance sheet for each period presented. Additionally, the securitizer should include qualitative information regarding the relationship between those assets and liabilities, such as if assets are restricted to satisfying a specific obligation, the nature of the restrictions placed on those assets. [810-10-50-4]

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Does FAS 167 require separate presentation? FAS 167 requires that entities consolidating a VIE separately present on the face of the balance sheet the (a) assets of that VIE which can only be used to settle its own obligations and (b) liabilities of that VIE for which the creditors or beneficial interest holders of the VIE do not have recourse to the general credit of the primary beneficiary. [810-10-25-45] This requirement has generated much discussion and debate, primarily because of the lack of guidance on how to apply this requirement to the balance sheet and that there is no similar requirement for presentation within the income statement and statement of cash flows. One of the common misconceptions about the separate presentation requirement is whether collapsing all of the VIEs assets into a single line item and all of the VIEs liabilities into a single line item is permitted. It is not permitted. However, instead, this information should be presented on a line by line basis, so that a VIEs assets should not be combined as a single asset line item and its liabilities should not be combined as a single liability line item, unless this is permitted by other GAAP. Accordingly, the assets of the securitization trust (which may include, for example, cash, loan receivables, and REO) should not be combined on the face of the balance sheet as a single line item unless they are the same category of asset. Because FAS 167 does not provide specific guidance on application of the separate presentation requirement, there are various presentation alternatives available. One alternative would be for an enterprise to present receivables as one line item and parenthetically disclose the amount of receivables in a VIE that meet the separate presentation criteria. A second alternative would be for an enterprise to present receivables in two separate line items (one line item for those that are in a VIE and meet the separate presentation criteria and another line item for all other receivables). The really clever preparer may find even more ways to meet this presentation requirement.25 Fortunately, the separate presentation requirement does not need to be applied on a VIE by VIE basis. Also, as mentioned above, FAS 167 is silent with regard to presentation requirements on the income statement and the statement of cash flows. An entity is permitted to present the activities of consolidated VIEs separately in both statements through an accounting policy election applied consistently to all consolidated VIEs. Some entities may choose to do this, at least initially, to improve comparability with prior periods. Eureka! I have sale accounting! What do I need to disclose? For securitizations that achieve sale accounting and the transferor has some form of continuing involvement with those transferred assets, FAS 166 requires specific disclosures for each income statement period presented in the financial statements. The transferor should disclose: information about the characteristics of the transfer, including the nature of the continuing involvement the type and initial fair value of the assets obtained and any liabilities incurred as part of the transfer, and the gain or loss recognized resulting from the sale. [860-20-50-3(b)]

25

For example, 810-20-45-1 addresses a similar question related to the consolidation of limited partnerships by stating: An entity [that consolidates a limited partnership] has financial statement and disclosure alternatives that may provide additional useful information. For example, an entity may highlight the effects of consolidating a limited partnership by providing consolidating financial statements or separately classifying the assets and liabilities of the limited partnership(s) on the face of the balance sheet.

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For those initial fair value measurements, the transferor also should disclose the level at which the measurements fall within the fair value hierarchy, the key inputs and assumptions used in the measurement, and the valuation techniques utilized. [860-20-50-3(bb), 3(c), and 3(cc)] For the key considerations in determining the fair value of the interests, please see Chapter 8, How do I measure and report fair value information?. Also, the footnote disclosure needs to contain information about the cash flows between the transferor and transferee. FAS 166 requires disclosure of proceeds from new transfers, proceeds from collections reinvested in revolving facilities, purchases of previously transferred assets, servicing fees, servicing advances, and cash flows received from a transferors beneficial interests in the transferred assets. [860-20-50-3(d)] For each balance sheet presented in the financial statements, FAS 166 requires the following, regardless of when the transfer occurred: Transferors should provide qualitative and quantitative information regarding their continuing involvement. The purpose of this requirement is to provide users of financial statements with information necessary to assess the reason for the continuing involvement and the exposure to risks the transferor retains. Transferors should also disclose the extent of any changes in their risk profile as a result of the transaction, including consideration of credit risk, interest rate risk, and other risks. Information to be disclosed as a result includes: the total outstanding principal amount, the amounts derecognized, and any amounts that continue to be recognized in the balance sheet information on any arrangements that could require the transferor to potentially provide financial support to the transferee or its beneficial interest holders and whether any financial support has been provided in the periods presented, including the type and the amount of support and the primary reasons for providing the support information about any third-party provided liquidity arrangements, guarantees, or other commitments related to the transferred financial assets Securitizers should disclose its accounting policies for subsequent measurements of the assets or liabilities related to the continuing involvement, as well as the key inputs and assumptions used in measuring the fair value of those assets or liabilities, including quantitative information about discount rates, expected prepayment speeds, and anticipated credit losses. A sensitivity analysis or stress test, usually presented in tabular format and displaying the hypothetical effect on the fair value of the transferors interests in the transaction of two or more unfavorable variations from the expected levels for each key assumption. To this, a description of the objectives, methodology, and limitations of the sensitivity analysis or stress test should also be disclosed. Finally, the securitizer should disclose information on the quality of the transferred financial assets, along with information on the same asset classes that are managed by the securitizer. This information should be categorized as pertaining to those assets derecognized and those that continue to be recognized within the balance sheet, and should include, but is not limited to, delinquencies and credit losses, net of recoveries. [860-20-50-4] What are the disclosure requirements with respect to servicing assets and liabilities? For recognized servicing assets and servicing liabilities, securitizers should disclose: the basis for determining the classes of servicing assets and servicing liabilities
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 a description of the inherent risks associated with servicing assets and servicing liabilities and a description of any instruments used to mitigate the income statement impact of changes in fair value changes of servicing assets and servicing liabilities the amount of contractually specified servicing fees, late fees, and ancillary fees earned, including where each of those amounts is recorded, for each income statement period presented quantitative and qualitative information regarding the assumptions used to estimate fair value, such as discount rates, anticipated credit losses, and prepayment speeds [860-50-50-2] For those servicing assets and servicing liabilities subsequently measured at fair value, FAS 166 also requires a disclosure of where the changes in fair value are reported in the income statement for each period presented and a rollforward of the activity for each class of servicing assets and servicing liabilities, including, the beginning balance, additions from (1) purchases of servicing assets or assumptions of servicing obligations and (2) recognition of servicing obligations that result from transfers of financial assets, disposals, changes in fair value, and the ending balance. [860-50-50-3] Similarly, for servicing assets and servicing liabilities carried at amortized cost, FAS 166 requires disclosure of the changes in the carrying amount of the servicing assets and servicing liabilities and where such changes are reported in the income statement and a rollforward of the activity for each class of servicing assets and servicing liabilities, including the beginning balance, additions from (1) purchases of servicing assets or assumptions of servicing obligations and (2) recognition of servicing obligations that result from transfers of financial assets, disposals, amortization, application of any valuation allowance to adjust the carrying value of servicing assets, any other-than-temporary impairments, any other changes that affect the balance and a description of those changes, and the ending balance. Additionally, for each class of servicing assets and servicing liabilities carried at amortized cost, securitizers should disclose the fair value of those recorded servicing assets and servicing liabilities at the beginning and end of the period; finally, the risk characteristics considered in the measurement of any impairment of servicing assets and a rollforward by class for any recognized impairment of servicing assets carried at amortized cost should also be disclosed. [860-50-50-4]

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What is going to happen to segment reporting? To begin with, footnote reporting of operating segments [280-10-50] is driven by the boss. The identification of operating segments depends on how the company reports operating results to the CEO, COO, or whatever person or group makes resource allocation decisions for the company as its chief operating decision maker. A primary purpose of segment disclosures is to show readers how a company is managed, so different companies will likely have different segments, even if they are in similar businesses. Depending on how previously unconsolidated VIEs are reported internally for management purposes, they could either represent one or more separate segments or they could become part of an existing segment or two. You could even imagine the now-consolidated VIEs reducing the number of reportable segments. An example might be a mortgage banker whose management reporting follows its external financial reporting. If it no longer reports gain on sale and service fee income to the chief operating decision maker, it might no longer have separate reportable segments for origination and servicing. It might conclude that it now only has a single mortgage lending segment. It is hard to imagine that a consolidated VIE would not be an operating segment, or part of one, because even VIEs would have the segment characteristics of business activities generating revenues and expenses, reported as discrete financial information, subject to regular review to assess performance and allocate resources. A segment should be reported if it meets one of the 10 percent significance thresholds (combined internal and external revenues, absolute value of segment profit or loss, and combined segment assets). Segments representing at least 75 percent of external revenue should be shown. Segments with similar economic characteristics, such as gross margin, products, services customers, production, distribution, and regulatory environment can be combined for reporting. Segment reporting is required in both annual and interim financial statements for public companies. Any other disclosures to consider? In addition to the specific disclosures discussed above, there can also be incremental disclosure considerations with respect to fair value or derivatives, for example, or for those loans within consolidated securitization structures measured on an amortized cost basis, there would be disclosures required for the allowance for loan losses. Reporting entities will need to consider all the potential additional disclosures that may be required from the consolidation of the securitization structures where they are determined to be the primary beneficiary. Illustrative disclosure26 NoteXX Securitization Transactions and Variable Interest Entities We securitize a variety of loans, including residential mortgage, commercial real estate, credit card, and automobile loans through consolidated and unconsolidated SPEs. In a securitization, we transfer assets to a SPE who then converts those assets into cash, through the issuance of commercial paper, senior and subordinated notes, and pass-through certificates. Our continuing involvement with securitizations
26

Some of the disclosure information is provided on an aggregated basis rather than detailing out by product type, which may be more appropriate depending on the specific circumstances. Because of space considerations, some tables have been truncated to only illustrate one years disclosure, even though comparative disclosures may be required.

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for which sale accounting is achieved typically is in the form of servicing the loans held by the SPEs or through holding a residual interest in the SPE. These transactions are structured without recourse, so our exposure is limited to standard representations and warranties as seller of the loans and responsibilities as servicer of the SPEs assets. Several of these SPEs are considered VIEs under U.S. GAAP. We are required to consolidate any VIEs in which we are deemed to be the primary beneficiary through having (1) power over the significant activities of the entity and (2) having an obligation to absorb losses or the right to receive benefits from the VIE which are potentially significant to the VIE. We are typically considered to have the power over the significant activities of those VIEs in which we act as the servicer or special servicer to the financial assets held in the VIE. Our servicing fees are typically not considered potentially significant variable interests in the VIE; however, when we retain a residual interest in the SPE, either in the form of a debt security or equity interest, we will often have an obligation to absorb losses or the right to receive benefits that would potentially be significant to the SPE. In those instances, we would be identified as the primary beneficiary of the VIE and required to consolidate it within our consolidated financial statements. We are not required, and do not currently intend, to provide any additional financial support to our sponsored securitization SPEs, whether or not consolidated. Investors and creditors only have recourse to the assets held by the SPE. The table below details the total principal outstanding, as well as historical loss and delinquency amounts for the managed portfolio for 20X3 and 20X2 (dollars in millions): Delinquent principal over 60 days $6.3 46.8 38.1 5.0 $96.2 $22.6 1.2 72.4 $96.2 Average balance (optional) $132 970 720 79 $1,901 Credit losses (net of recoveries) $4.6 35.6 26.2 6.0 $72.4

Total principal amount of loans Type of Loan Automobile Residential mortgage Commercial mortgage Credit card balances Total loans managed Comprised of: Loans held in portfolio Loans held for sale or securitization Loans securitized Total loans managed $452 119 1,349 $1,920 $120 982 744 74 $1,920

At December 31, 20X3

Year ended December 31, 20X3

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The table below provides information about our maximum exposure to loss from our continuing involvement with unconsolidated VIEs and the overall asset size of those VIEs as of December 31, 20X3 and 20X2 (dollars in millions): Maximum exposure to loss in significant unconsolidated VIEs Funded exposures December 31, 20X3 Automobile loans Residential mortgage Commercial mortgage Credit card balances Total Assets of SPEs $ 96 741 438 74 $1,349 Debt investments $18.6 48.8 36.5 14.2 $118.1 Equity investments $ $ Unfunded exposures Funding commitments $ $ Guarantees and derivatives $ $

The table below details the components of our securitized loans receivable held by consolidated VIEs and the related asset-backed securities issued by those VIEs as of December 31, 20X3 and 20X2 (dollars in millions):

Variable interest entities December 31, 20X3 Automobile securitizations Residential mortgage securitizations Commercial mortgage securitizations Credit card revolving securitizations Total Variable Interest Entities

Securitized loans receivable $ 88 645 432 172 $1,337

Asset-backed securities issued $ 80 607 396 138 $1,221

We recorded net gains from securitizations of $53 million, $78 million, and $67 million during 20X3, 20X2, and 20X1, respectively. Net gains reflect the (1) gain/(loss) from new securitizations, (2) the reversal of the allowance for loan losses associated with receivables sold, and (3) the net gains on replenishing the SPEs assets offset by any other-than temporary impairments. We continue to perform servicing for some of these securitizations and recognized servicing assets of $12 million, $49 million, and $32 million in 20X3, 20X2, and 20X1, respectively.

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The following table summarizes selected cash flow information related to securitizations for the years 20X3, 20X2, and 20X1 (dollars in millions): 20X3 Proceeds from new securitizations Proceeds from collections reinvested in revolving receivables Contractual servicing fees received Cash flows received on retained interests and other net cash flows $118.4 90.1 11.8 6.2 20X2 $326.8 165.8 12.2 16.3 20X1 $ 23.2 124.5 12.0 14.2

We carry our retained interests in our sponsored securitization VIEs as trading securities carried at fair value with changes in fair value recognized in earnings. The key economic assumptions used in measuring the fair value of our retained interests resulting from securitizations completed during 20X3 and 20X2 (weighted based on principal amounts securitized) were as follows [for simplicity, disclosures for 20X2 are not included below]: Automobile loans Prepayment speed (annual rate) Weighted-average life (in years) Expected credit losses Residual cash flow discount rates Interest rates on adjustable loans and bonds 1.00% 1.80 1.10% 2.40% 13.30% Credit card loans 15.00% 0.50 6.10% 12.2% Residential mortgage 10.00% 7.80 1.25% 11.6% Commercial mortgage 8.00% 6.50 1.30% 10.09%

Forward eurodollar yield curve, plus contractual spread over LIBOR ranging from 30 to 80 basis points

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At December 31, 20X3, key economic assumptions and the sensitivity of the current fair value of residual cash flows to immediate 10 percent and 20 percent adverse changes in those assumptions are as follows (dollars in millions): Automobile Residential Commercial loans mortgages mortgages Balance sheet carrying value of interests at fair value Weighted-average life (in years) Prepayment speed assumption (annual rate) Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Expected credit losses (annual rate) Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Residual cash flows discount rate (annual) Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Interest rates on variable and adjustable loans and bonds Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change $18.6 1.7 1.3% $0.3 $0.7 3.0% $2.2 $4.4 14.0% $1.0 $1.8 $48.8 6.5 11.5% $6.3 $12.8 0.9% $1.1 $2.2 12.0% $1.6 $2.9 $36.5 6.1 9.3% $4.6 $9.0 1.8% $1.2 $3.0 12.0% $1.2 $2.5 Credit card loans $14.2 0.4 15.0% $0.6 $1.2 6.1% $3.3 $6.5 14.0% $0.1 $0.1

Forward eurodollar yield curve plus contract spread $0.8 $1.5 $1.4 $2.7 $2.5 $4.8 $1.2 $2.4

These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.

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Chapter 13 What about reporting? Regulation AB and a look into the reporting future
In 2005, the SEC issued its 495-page Regulation AB (17 CFR 229.1100). The rules and related forms update and clarify the Securities Act registration requirements and Exchange Act periodic reporting for asset-backed securities offerings; among other things, the Regulation also has about 30 pages devoted to Section 1122 on assessments of compliance with the SECs minimum servicing criteria for mortgage and asset-backed securities and attestation reports by accounting firms on such assessments. The SECs minimum servicing criteria appear at the end of the chapter. The SEC does not require audited financial statements for the issuing entity in either prospectuses or 10-K annual report filings. Often a new issuing entity is created for each transaction, so prior financial information about that entity would not exist. Regulation AB (Reg AB) attempted to address investors concerns regarding adequate reporting on the financial performance of a securitization after the deal had closed; in the wake of the credit crisis, however, there have been renewed demands for greater transaction transparency. See Given the increased demands for reporting transparency, what is on the horizon?, below. Currently, however, Reg AB is the one standard that is required for securitizations that are registered with the SEC. Prior to the enactment of Reg AB, the Uniform Single Attestation Program (USAP) was the most common reporting used for assessing servicers compliance with the procedures that were outlined in the transaction documents. Since Reg ABs appearance, however, the migration in the industry has been to replace the requirement for USAP reporting with Reg ABs reporting regime, with the result that not only public securitizations, but many privately placed transactions, have contractual requirements that mandate the distribution of a Reg AB report on an annual basis. In its deliberations leading to the implementation of Reg AB, the SEC determined what it thought was information which was meaningful to investors. While an annual audit has the benefits of providing some assurance with respect to controls over the administration of the transaction and the pool assets, the SEC originally indicated that their amendments to require registered public accounting firm attestation reports as to assessments of compliance with particular servicing criteria are a more direct and targeted approach to achieve such objectives. Similarly, the SEC expressed the view that one of the other objectives for financial statements to present results of financial activity during a period can be addressed more particularly by their disclosure requirements regarding distributions on the asset-backed securities than through the preparation of financial statements. What is the timing? There is no requirement that the year-end adopted by the ABS registrant be the same as the year-end of its sponsor. However, the reporting period for the 10-K and the reporting period for the servicing reports should be coterminous. Should the transaction be a private transaction, however, then there are no such timing constraints, although the issuer should be mindful of timing requirements specified in the transaction documents. Many securitizers find it easiest to have the sponsors and transactions year-end to be the same, since the Reg AB procedures can be easily integrated into the sponsors annual financial audit.
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A 10-K report is required for the fiscal year in which the takedown off of a registration statement occurs. If, at the beginning of the next fiscal year, the securities of each class in the takedown are held of record by fewer than 300 persons, a Form 15 may be filed and no further annual or periodic distribution reports need be filed, which is the typical situation. Whats the difference between assertion, assessment, attestation, statement, and certification? Who issues each one? The 10-K must include, among other things: assessments of compliance with the SECs minimum servicing criteria from each party participating in the servicing function (Section 1122) accountants attestation reports evaluating each servicers assertion in their assessment of compliance with the minimum servicing criteria (Section 1122) statements from each servicer to the effect that the servicer has fulfilled its obligations under the servicing agreement for the particular transaction (Section 1123) a certification by the person signing the 10-K that the 10-K and Form 10-D distribution reports do not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made not misleading, and that all assessments and attestations required to be included have been included, except as otherwise disclosed (Section 302) The person responsible for signing the Sarbanes-Oxley Section 302 certification must certify that all of the reports on assessment of compliance with the entire servicing function and their related attestation reports required to be included in the 10-K have been included as an exhibit to the 10-K, except as otherwise disclosed. Further, any material instances of noncompliance described in such reports must be disclosed in the 10-K. The certification must be signed either on behalf of the depositor by the senior officer in charge of securitization of the depositor or on behalf of the issuing entity (e.g., trust) by the senior officer in charge of the servicing function of the servicer. If a servicer is to sign the report on behalf of the issuing entity and multiple servicers are involved in the servicing of the pool assets, the senior officer in charge of the servicing function of the master servicer (or entity performing the equivalent function) must sign. The trustee is not permitted to sign the report as an alternative to the depositor or the servicer. Who must submit a servicers assessment of compliance? The 10-K must include assessments of compliance from each party participating in the servicing function. A party participating in the servicing function means any entity (e.g., master servicer, primary servicers, and trustee) that is performing activities that address the minimum servicing criteria unless such entitys activities relate only to 5 percent or less of the pool assets. The 5 percent is to be calculated based on the principal balance of the assets, based on a weighted-average throughout the year covered by the 10-K. Again, since the implementation of Reg AB, however, more and more transaction documents have incorporated the need for Reg AB reporting, regardless of the extent of the entitys involvement, i.e., regardless of the 5 percent requirement. Each party participating in the servicing function will be responsible for having an attestation engagement performed by a registered public accounting firm. What if I rely on vendors for part or all of the servicing function? Many questions emerged as to the ramifications on Reg AB testing if the servicer relied on a vendor or
114 Securitization accounting

vendors in accomplishing aspects of the servicing function. In response, the SEC issued the following guidelines: A vendor engaged by a servicer to perform specific and limited activities or to perform activities scripted by the servicer would not be viewed as a party participating in the servicing function separate and apart from the servicer engaging such vendor, and would not need to submit separate assessment and attestation reports for inclusion in the related asset-backed issuers Form 10-K report if: The vendor is not a servicer as defined in Item 1101(j) of Regulation AB (i.e., it is responsible for the management or collection of the pool assets or making allocations or distributions to holders, regardless of the entitys title); The servicer engaging and monitoring the vendor elects to take responsibility for assessing compliance with the servicing criteria applicable to that vendor in the servicers report regarding assessment of compliance with servicing criteria; The servicer engaging the vendor has policies and procedures in place designed to provide reasonable assurance that the vendors activities comply in all material respects with the servicing criteria applicable to the vendor; and The servicers report on assessment of compliance discloses: the servicing criteria or portion of servicing criteria applicable to the vendors activities for which the servicer is assuming responsibility; any material instance of noncompliance by the vendor that the servicer identifies or of which it is aware; and any material deficiency that is identified in the servicers policies and procedures to monitor the vendors compliance. In this situation, consistent with Item 1122(d)(1)(ii) of Reg AB and Instruction 2 to Item 1122 of Reg AB, the requirement to assess compliance with the servicing criteria applicable to a vendors activities is satisfied if the servicer has instituted policies and procedures to monitor whether such vendors activities comply in all material respects with such criteria. Compliance with the applicable servicing criteria is achieved if those policies and procedures are designed to provide reasonable assurance that such vendors activities comply with such criteria and those policies and procedures are operating effectively. Must there be an assessment for each individual transaction? Although a separate 10-K must be filed for each trust, the same assessment of compliance with the minimum servicing criteria required by Section 1122 can be filed in each of the 10-Ks. This means that the assessment is to be made on a platform level for that asset class (i.e., all transactions involving the asserting party that are backed by assets of the type backing the ABS covered by the particular 10-K). On the other hand, Section 1123 requires a statement of compliance regarding the servicers obligations under the particular servicing agreement for the ABS transaction rather than at the platform level. There is no requirement for an accountants attestation report on the Section 1123 servicer compliance statement with the particular servicing agreement for the ABS transaction. For example, if an entity-sponsored and serviced four mortgage loan transactions and four auto loan transactions in a given year, there would be a requirement for eight 10-Ks and eight section 1123 servicer compliance statements and eight section 302 Sarbanes-Oxley certifications, but only two section 1122 servicer assessments and only two accountants attestation reports (i.e., one for the mortgage platform
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and one for the auto loan platform). When multiple unaffiliated servicers are involved in a transaction, the math gets more challenging. What is meant by the entire servicing function? The servicing of an asset-backed security consists of many functions, including: collecting principal, interest and other payments from obligors; paying taxes and insurance from escrowed funds; monitoring and accounting for delinquencies; executing foreclosure if necessary; temporarily investing funds pending distribution; remitting fees and payments to enhancement providers, trustees and others providing services; and allocating and remitting distributions to security holders. The minimum servicing criteria are separated into four categories, which are reproduced below: general servicing considerations cash collection and administration investor remittances and reporting pool asset administration (refer to the end of this chapter for detailed criteria) What if some of the SECs criteria are not applicable to my activities? A servicer may exclude a particular criterion either because in its servicing platform it does not participate in that element of the servicing function or the criterion is broadly inapplicable in the context of the asset class being serviced. However, a party may not voluntarily select to exclude specific servicing criteria if they are otherwise applicable to that party. In the event that servicing criteria are excluded for those reasons that are permitted, the inapplicability of the criteria must be disclosed in both the asserting partys assertion and the related registered public accounting firms report. However, while the individual asserting parties will be permitted to exclude criteria they do not perform, the person making the Section 302 certification must certify whether all required reports covering the entire servicing function, including all the criteria applicable to the asset class, are included with the 10-K. Are there penalties for instances of noncompliance with the servicing criteria? What if instances of noncompliance are subsequently corrected in the period? Disclosure will be required of material instances of noncompliance during the reporting period, even if such noncompliance was subsequently corrected in the period. It should be noted, however, that reports on assessment of compliance with servicing criteria under Item 1122 of Regulation AB do not have to include instances of noncompliance with the servicing criteria if the instances of noncompliance are not material to the servicing platform. However, a servicer may need to disclose in the Item 1123 servicer compliance statement an instance of noncompliance with servicing criteria that is material to the servicing of the specific asset pool covered by the report on Form 10-K, even if the instance of noncompliance is not disclosed in the Item 1122 report. A material instance of noncompliance identified in the reports will not, by itself, have regulatory restrictions on market access, such as an effect on continued Form S-3 eligibility for additional ABS transactions. Rather, the assessment and reporting on the criteria is designed to operate within a disclosure-based framework that the SEC believes will promote investor confidence and market efficiency by decreasing information asymmetries and promoting more efficient pricing and valuation of the securities, as well as competition among issuers. What happens if the servicing function changes during the reporting period? Coincident with the increase in transactions with respect to bank acquisitions, as well as the assumption of
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asset portfolios, many questions have been raised about what impact those transactions have on the Reg AB reporting requirements. As a general rule, if a bank acquires an entire business operation, including management, then there should be enough knowledge for management to give the required assessments with respect to servicing compliance for the entire year under review. If, on the other hand, servicing changes hands, then at least two reports would be required, subject to the de minimis tests outlined above, since management would not have the requisite knowledge on which to base its assessment of compliance for the entire year. The appropriate determination as to what is required is ultimately a legal judgment, so consultation with counsel is recommended. What is static pool reporting? Not to be forgotten, Reg AB also has disclosure requirements for pool data in an effort to assist investors in their assessment of expected future pool performance and credit risk. Reg AB requires, to the extent material, disclosure of static pool information. The static pool information is to be disclosed on a periodic basis, either monthly or quarterly, and include disclosures regarding delinquencies, cumulative losses, and prepayments for the respective asset type. The rules call for information, to the extent material, for a minimum of five years (or such shorter period if the sponsor has been either securitizing assets of the same asset type in the case of seasoned sponsors or making originations or purchases of assets of the same type in the case of unseasoned sponsors). Given the increased demands for reporting transparency, what is on the horizon? The ABS Act! In the wake of the financial tumult in the past few years, most participants in the securitization industry agree that there will be an increase in reporting to meet the demand for greater transactional transparency for investors. That said, there has been little agreement as to what will constitute those new requirements. In a speech to SIFMA in October, 2009, the Chairman of the SEC, Mary Shapiro, stated: Most legislative proposals aimed at improving securitization, suggest amendments to the securities laws that are focused on the disclosure of material information. But substantive protections beyond disclosure requirements are needed for the ABS arena. Thats because of the unique character of securitization and the role it plays in the national economy. Creating a new act directed solely at securitizations would allow Congress to specifically tailor solutions for these investment vehicles much like the Investment Company Act of 1940. And, it could be done without compromising or changing the fundamental structure and underpinnings of existing statutes. Similar to the Investment Company Act, the ABS Act could have substantive restrictions or requirements for the trust that issues the securities and for related parties. Such a statute could set minimum requirements for the pooling and servicing agreements, such as requiring strong representations and warranties about the assets being securitized and procedures for ensuring those representations and warranties are followed. Thats in addition to the disclosure requirements of the Securities Act, which would continue to apply when ABS securities were offered and sold. Among industry participants, there have been many ideas bandied about. Some thoughts center around further reporting on servicing; others focus on ensuring that all the required documentation underlying the assets in the pool is in place and conforms to the transaction documents. Still others talk about the need for transactional financial statement reporting. We cant wait to see how all this turns out!
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The SECs Minimum Servicing Criteria 1. General servicing considerations. i. Policies and procedures are instituted to monitor any performance or other triggers and events of default in accordance with the transaction agreements. ii. If any material servicing activities are outsourced to third parties, policies and procedures are instituted to monitor the third-partys performance and compliance with such servicing activities. iii. Any requirements in the transaction agreements to maintain a back-up servicer for the pool assets are maintained. iv. A fidelity bond and errors and omissions policy is in effect on the party participating in the servicing function throughout the reporting period in the amount of coverage required by and otherwise in accordance with the terms of the transaction agreements 2. Cash collection and administration. i. Payments on pool assets are deposited into the appropriate custodial bank accounts and related bank clearing accounts no more than two business days of receipt, or such other number of days specified in the transaction agreements. ii. Disbursements made via wire transfer on behalf of an obligor or to an investor are made only by authorized personnel. iii. Advances of funds or guarantees regarding collections, cash flows or distributions, and any interest or other fees charged for such advances, are made, reviewed and approved as specified in the transaction agreements. iv. The related accounts for the transaction, such as cash reserve accounts or accounts established as a form of overcollateralization, are separately maintained (e.g., with respect to commingling of cash) as set forth in the transaction agreements. v. Each custodial account is maintained at a federally insured depository institution as set forth in the transaction agreements. For purposes of this criterion, federally insured depository institution with respect to a foreign financial institution means a foreign financial institution that meets the requirements of 17 CFR 240.13k-1(b)(1). vi. Unissued checks are safeguarded so as to prevent unauthorized access. vii. Reconciliations are prepared on a monthly basis for all asset-backed securities related bank accounts, including custodial accounts and related bank clearing accounts. These reconciliations: (A) Are mathematically accurate; (B) Are prepared within 30 calendar days after the bank statement cutoff date, or such other number of days specified in the transaction agreements; (C) Are reviewed and approved by someone other than the person who prepared the reconciliation; and (D) Contain explanations for reconciling items. These reconciling items are resolved within 90 calendar days of their original identification, or such other number of days specified in the transaction agreements. 3. Investor remittances and reporting. i. Reports to investors, including those to be filed with the Commission, are maintained in accordance with the transaction agreements and applicable Commission requirements. Specifically, such reports: (A) Are prepared in accordance with timeframes and other terms set forth in the transaction agreements;
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(B) Provide information calculated in accordance with the terms specified in the transaction agreements; (C) Are filed with the Commission as required by its rules and regulations; and (D) Agree with investors or the trustees records as to the total unpaid principal balance and number of pool assets serviced by the servicer. ii. Amounts due to investors are allocated and remitted in accordance with timeframes, distribution priority, and other terms set forth in the transaction agreements. iii. Disbursements made to an investor are posted within two business days to the servicers investor records, or such other number of days specified in the transaction agreements. iv. Amounts remitted to investors per the investor reports agree with cancelled checks, or other form of payment, or custodial bank statements. 4. Pool asset administration. i. Collateral or security on pool assets is maintained as required by the transaction agreements or related pool asset documents. ii. Pool assets and related documents are safeguarded as required by the transaction agreements. iii. Any additions, removals, or substitutions to the asset pool are made, reviewed, and approved in accordance with any conditions or requirements in the transaction agreements. iv. Payments on pool assets, including any payoffs, made in accordance with the related pool asset documents are posted to the applicable servicers obligor records maintained no more than two business days after receipt, or such other number of days specified in the transaction agreements, and allocated to principal, interest or other items (e.g., escrow) in accordance with the related pool asset documents. v. The servicers records regarding the pool assets agree with the servicers records with respect to an obligors unpaid principal balance. vi. Changes with respect to the terms or status of an obligors pool asset (e.g., loan modifications or reagings) are made, reviewed and approved by authorized personnel in accordance with the transaction agreements and related pool asset documents. vii. Loss mitigation or recovery actions (e.g., forbearance plans, modifications, and deeds in lieu of foreclosure, foreclosures, and repossessions, as applicable) are initiated, conducted and concluded in accordance with the timeframes or other requirements established by the transaction agreements. viii. Records documenting collection efforts are maintained during the period a pool asset is delinquent in accordance with the transaction agreements. Such records are maintained on at least a monthly basis, or such other period specified in the transaction agreements, and describe the entitys activities in monitoring delinquent pool assets including, for example, phone calls, letters, and payment rescheduling plans in cases where delinquency is deemed temporary (e.g., illness or unemployment). ix. Adjustments to interest rates or rates of return for pool assets with variable rates are computed based on the related pool asset documents. x. Regarding any funds held in trust for an obligor (such as escrow accounts): (A) Such funds are analyzed, in accordance with the obligors pool asset documents, on at least an annual basis, or such other period specified in the transaction agreements; (B) Interest on such funds is paid, or credited, to obligors in accordance with applicable pool asset documents and state laws; and (C) Such funds are returned to the obligor within 30 calendar days of full repayment of the related pool asset, or such other number of days specified in the transaction agreements.
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xi. Payments made on behalf of an obligor (such as tax or insurance payments) are made on or before the related penalty or expiration dates, as indicated on the appropriate bills or notices for such payments, provided that such support has been received by the servicer at least 30 calendar days prior to these dates, or such other number of days specified in the transaction agreements. xii. Any late payment penalties in connection with any payment to be made on behalf of an obligor are paid from the servicers funds and not charged to the obligor, unless the late payment was due to the obligors error or omission. xiii. isbursements made on behalf of an obligor are posted within two business days to the D obligors records maintained by the servicer, or such other number of days specified in the transaction agreements. xiv. Delinquencies, charge-offs, and uncollectible accounts are recognized and recorded in accordance with the transaction agreements. xv. Any external enhancement or other support, identified in Item 1114(a)(1) through (3) or Item 1115 of Regulation AB, is maintained as set forth in the transaction agreements. Instructions to Item 1122 Servicer Assessments 1) If certain servicing criteria are not applicable to the asserting party based on the activities it performs with respect to asset-backed securities transactions taken as a whole involving such party and that are backed by the same asset type backing the class of asset-backed securities, the inapplicability of the criteria must be disclosed in that asserting partys and the related registered public accounting firms reports. 2) If multiple parties are participating in the servicing function, a separate assessment report and attestation report must be included for each party participating in the servicing function. A party participating in the servicing function means any entity (e.g., master servicer, primary servicers, or trustees) that is performing activities that address the criteria in paragraph (d) of this section, unless such entitys activities relate only to 5 percent or less of the pool assets. 3) If the asset pool backing the asset-backed securities includes a pool asset representing an interest in or the right to the payments or cash flows of another asset pool and both the issuing entity for the asset-backed securities and the entity issuing the asset to be included in the issuing entitys asset pool were established under the direction of the same sponsor and depositor, see also Item 1100(d)(2) of Regulation AB. What is the required form of the assessment? The assessment must include: A statement of the partys responsibility for assessing compliance with the servicing criteria applicable to it. A statement that the party used the servicing criteria to assess compliance with the applicable servicing criteria. The partys assessment of compliance with the applicable servicing criteria as of and for the period ending the end of the fiscal year covered by the 10-K. The report must include disclosure of any material instance of noncompliance identified by the party. A statement that a registered public accounting firm has issued an attestation report on the partys assessment of compliance with the applicable servicing criteria as of and for the period ending the end of the fiscal year covered by the 10-K.

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Appendix Solving the securitization puzzles

Asset Allocation
One reason that the securitization market exists, and hence why we even bothered to write this booklet, is that securitized assets often play an important role in the portfolio diversification strategies of investors as they try to optimize their risk versus return profiles. The following puzzles challenge you to include each of the nine different securitization asset classes listed below once, and only once, in each row, column, and 3x3 outlined square. The classes are: Auto loan receivables B-pieces Credit card receivables Easier I I H G C F D C I H D B H F H D E I E G D E H F D E H B F A D I E B G I A C F H E A B D H G F E C CDOs Exotic ABS Fannie & Freddie REMICs Ginnie Mae MBS HELOCs IO strips Harder B G C I H

The answers to these puzzles appear on the following pages.

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Find the words

The FASB Accounting Standards Codification is designed to make it easier to find important accounting guidance, including guidance related to securitization issues. Even so, many people, especially the non-accountants who we hope will benefit the most from this booklet, may sometimes still feel like they have to search high and low, forwards and backwards, and even diagonally, in order to find just the right reference. The following puzzle challenges you to find 50 securitization related words and phrases.

8 Y A L P G E L F I K 1 5 P 3

C R E D I T C A R D B P V R R

8 S G G R Y T J 6 I L A O D

5 S T A T T O R Y F C T O E

Y K 4 J S 6 3 3 9 U A I 9 T R

I 9 N K O D Q B 9 L S G T Z I

E 2 F FI I E C S L O B E E T V

L P V A N C M R P C R C T N A

D A S B V N K E D E 4

B 3 C W E O D O F E L

9 6 7 I S I A S U I A E N V

M Q Y Y W T T N 7 S T U E R U E D 8 4 O A B 4 A F D R Y O 0

C I M E R U I 9 P A I C C C Q

Q S Y T E L X V C S S I T C N

E C Z O A 7 L D 1 E A P A O

U L E P V I N N 6 R L U L I

3 O R T R H O S 6 7 I P R C T

8 S O I D B K 1 S U S A K T A

Y U C O K S S 1 H U K P N I L

U R O N L A W Y E R E E A O O

G E U Q F I 4 6 L D P R B S

X J P G 6 E S U O H E R A I

E Z O N I T A C I F I D C

M I N I U M S V H C Y O H G

W A

O M

M U

O M M O M A T T I

N W O

ACCOUNTANT AGENT AU 9336 AUCTION BANKRUPTCY REMOTE CALL CDO CODIFICATION COMMERCIAL PAPER CREDIT CARD

DEPOSITOR DERIVATIVE DISCLOSURE EITF FAS 166 FAS 167 FASB FDIC FFIEC HELOC

IAS 39 IASB INVESTOR IO STRIP ISOLATION ISSUER JUNK BONDS KICKOUT LAWYER MINIMUM

NAIC OPTION OTTI PUT QSPE REMIC REO RESIDUAL REWARD RISK

ROAP SILO STATUTORY TRANSFERETTE USAP VALUATION VIATICAL WAREHOUSE YIELD ZERO COUPON

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Vocabulary Builder
Use the letters in SECURITIZATION ACCOUNTING to make as many common words or two-word phrases as you can. Capitalized words, such as place names, are fine. For two-word phrases, such as cost accounting, we counted the space as a letter for scoring. Hyphenated words dont count, because there is no hyphen in securitization accounting. Our computers high score so far is:

Letters used 17 or more 16 15 14 13 12 11 10 9 8 7 6 5 4 3 Total

Number of words Deloitte 0 1 2 7 24 58 109 206 296 462 657 612 559 398 158 3,549 You

Score: Letters used x Number of words Deloitte 0 16 30 98 312 696 1,199 2,060 2,664 3,696 4,599 3,672 2,795 1,592 474 23,903 You

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Easier B F H G D C I A E A I G E B H D F C C E D F I A B G H E H A I G D C B F F G C B A E H D I I D B C H F G E A H B I A F G E C D D A E H C B F I G G C F D E I A H B G D I E F H B A C E A H C B G F I D C F B A I D G E H A C D F H B I G E

Harder B G E D C I H F A H I F G E A C D B F E G B D C A H I I B A H G E D C F D H C I A F E B G

8 Y A L P G E L F I K 1 5 P 3

C R E D I T C A R D B P V R R

8 S G G R Y T J 6 I L A O D

5 S T A T T O R Y F C T O E

Y K 4 J S 6 3 3 9 U A I 9 T R

I 9 N K O D Q B 9 L S G T Z I

E 2 F FI I E C S L O B E E T V

L P V A N C M R P C R C T N A

D A S B V N K E D E 4

B 3 C W E O D O F E L

9 6 7 I S I A S U I A E N V

M Q Y Y W T T N 7 S T U E R U E D 8 4 O A B 4 A F D R Y O 0

C I M E R U I 9 P A I C C C Q

Q S Y T E L X V C S S I T C N

E C Z O A 7 L D 1 E A P A O

U L E P V I N N 6 R L U U I

3 O R T R H O S 6 7 I P R C T

8 S O I D B K 1 S U S A K T A

Y U C O K S S 1 H U K P N I L

U R O N L A W Y E R E E A O O

G E U Q F I 4 6 L D P R B S

X J P G 6 E S U O H E R A I

E Z O N I T A C I F I D C

M I N I U M S V H C Y O H G

W A

O M

M U

O M M O M A T T I

N W O

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Securitization answers not just questions

Choose Deloitte when looking for a professional services organization you can trust deep industry specialists that mobilize to offer our clients a broad complement of securitization services and products. At Deloitte, we have specialists located both in the U.S., as well as in all principal financial centers around the globe. Our understanding of this industry and its challenges, the depth of knowledge, our range of experience, and the quality and value that our people deliver are hard to beat. Throughout all phases of the securitization life cycle from origination through post closing our securitization specialists deliver quality, value, objectivity and insight. As you originate, structure, or manage a securitization, use our services and receive thoughtful guidance to assist you in achieving transaction objectives while balancing real life operational and infrastructure constraints. At every step of the way, we provide services and products designed to be responsive to the challenges that lie in your path. Advisory services focused on: Accounting, tax and regulatory evaluation Implementation and compliance with accounting, and tax and regulatory requirements Facilitating organizational and process assessment and redesign Identifying and implementing improvements to operational controls, processes and procedures Development and delivery of customized training Insights into the assumptions and processes underlying structured asset valuation Transaction services that enable securities offerings: Collateral due diligence Cash flow modeling Portfolio analytics Offering document review Agreed-upon procedures reporting Compliance services support transaction administration through: Testing of covenant compliance monitorings Modeling and recalculating securities payment activity Review and analysis of remittance reports Preparation of REMIC tax returns Proprietary technology products that streamline: Investor reporting and securities payment calculations Collateral selection, management, and analysis Surveillance needs for tracking and analyzing securitization investment portfolios Implementation of AICPA SOP 03-3 asset tracking, calculation, and reporting Understanding our clients needs, and responding to them quickly, and delivering consistent, knowledgeable advice and strategic thinking this is the cornerstone of our client service philosophy. It has made us a leading global provider of services and products to the securitization industry. Since the inception of the award in 1999, Deloitte has been honored as the Best Securitization Accounting Firm by International Securitisation Report.

Visit us at www.deloitte.com/us/securitization

To be continued...

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication. As used in this document, Deloitte means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Copyright 2010 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu