S E C U R I T I Z AT I O N A C C O U N T I N G U N D E R FA S B 1 2 5

Y2K EDITION / JANUARY 2000

Securitization Accounting Under FASB 125

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by Marty Rosenblatt and Jim Johnson

125

To our clients and friends: Who would have thought that securitization accounting would be such a dynamic topic? The FASB, the EITF the FDIC, the AICPA and the SEC have proposed and promulgated rules, policies and inter, pretations at a relentless pace, necessitating a fourth edition of our booklet. As with the prior editions, this booklet is written in general terms as a guide only. The actual application of FASB 125 should be determined by all relevant facts and circumstances, and we recommend that readers seek up-to-date information regarding any particular problem they encounter. Equity analysts and rating agencies have been extremely critical of the quality of earnings of many securitizers. They point out that FASB 125 gains are, for the most part, paper prots. They characterize gain-on-sale accounting as front-ending income by recording "soft" assets that represent an estimate of the present value of anticipated income. In response, several securitizers have reported that they would adopt more conservative assumptions, while others have recently announced that they would discontinue the use of gain-on-sale accounting altogether. However, in order to report a zero up-front gain, the securitization must be structured as a nancing rather than a sale in virtually every case. This debt-for-GAAP treatment has most commonly been implemented by inserting a call option that is not just a cleanup call. Management often objects to debt-for-GAAP treatment because the balance sheet balloons with debt which has negative implications on debt/equity ratios, return on assets and debt covenant compliance. The FASB continues to maintain that gain [or loss] on sale accounting is the most appropriate (and conceptually sound) treatment whenever a sale has occurred, and that FASB 125 contains appropriate guidance for determining whether a sale has occurred, and for recording the retained interests.To resolve this conict, our rm has encouraged the FASB to consider adopting for certain securitizations a linked presentation approach, in which the pledged assets remain on the balance sheet but the non-recourse securitized debt is reported as a direct deduction from the pledged assets (rather than as a liability). At the time of this writing, we have no indication that the FASB will give serious consideration to our proposal, but we remain hopeful. In the meantime, the FASB has proposed extensive new disclosures relating to securitizations accounted for as sales, including the number and volume of transactions, cash inows (outows) with the securitization trusts, disclosure of prepayment, loss, discount rate and other assumptions, static pool loss analysis and multiple stress tests or sensitivity analyses for the value of the retained interests. Some securitizers provide supplemental information showing key nancial statement components on a pro forma basis, as if their off-balance sheet securitizations were on balance sheet. The FASB considered, but rejected, this type of presentation as a required component of the new disclosures. We make a constant effort to stay current in this ever-changing market, and hope that this effort is reected in the following pages. At the time of this writing, the FASB has proposed signicant amendments to FASB 125, which we cover starting on page 42 of this booklet. If adopted, the amendments (currently expected in the second quarter of 2000) are likely to become effective in 2001. Accordingly, readers should not apply the guidance in this booklet post-2000. We have shaded the areas in this booklet where the rules are scheduled to change as a result of the proposed amendments to FASB 125. We intend to prepare another edition of this booklet when the new rules are adopted in nal form. Thank you for your continuing interest. We look forward to providing further updates in the months and years ahead. Sincerely,

If you would like to receive our periodic bulletin, S.O.S.-Speaking of Securitization, covering accounting, tax, regulatory and other developments affecting the securitization market, just send an e-mail to sst-los_angeles@dttus.com.

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Securitization Accounting Under FASB 125

Y2K

EDITION
JANUARY 2000

125

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1 2

What is FASB 125, and when does it apply? FASB 125 applies to: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 FASB 125 does not apply to: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Determining whether the securitization meets the sale criteria When is a securitization accounted for as a sale? . . . . . . . . . . . . . . . . . . . . . 6 What about puts and calls? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Must a qualifying special-purpose entity be brain dead? . . . . . . . . . . . . . . 8 Do QSPEs get consolidated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 What if the issuer is not a QSPE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Is it possible to structure debt-for-tax as a sale for GAAP? . . . . . . . . . . . . . 11 Can warehouse funding arrangements be off-balance sheet? . . . . . . . . . . 13 Can I convert loans to securities on my balance sheet? . . . . . . . . . . . . . . . .15 Why do the assets have to be isolated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Do banks have to isolate their assets to get sale treatment? . . . . . . . . . . . . 16 Do I always need a lawyers letter? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Can a QSPE ever sell its assets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 What if the transfer does not qualify as a sale? . . . . . . . . . . . . . . . . . . . . . . 21 And if it does qualify as a sale? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

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Questions related to determining gain or loss on sale Can I elect not to recognize gain on sale? . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 What if I cant reasonably estimate fair value? . . . . . . . . . . . . . . . . . . . . . . . 28 How is gain or loss determined in a revolving structure? . . . . . . . . . . . . . . 28 How about an example of a gain on sale worksheet or template? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 How about a credit card example? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Is fair value in the eyes of the B-holder? . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Does FASB 125 guide the separate nancial statements of the SPE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Can I record an asset for servicing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Should I record a liability for retained credit risk? . . . . . . . . . . . . . . . . . . . . 35 How are cash reserve accounts handled? . . . . . . . . . . . . . . . . . . . . . . . . . . 36 How does FASB 125 treat interest-only strips? . . . . . . . . . . . . . . . . . . . . . . . 37 Are there any special rules for mortgage bankers? . . . . . . . . . . . . . . . . . . . 39 What if we put Humpty-Dumpty back together again? . . . . . . . . . . . . . . . . . 40

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Stay tuned for further developments Whats slated for 2001? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 The FASBs proposed new disclosures . . . . . . . . . . . . . . . . . . . . . 45 Test your knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Index

what is

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APPLY?

125
AND WHEN DOES

it

The Financial Accounting Standards Boards Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, went into effect starting with 1997 transactions.1 The FASB staff and the Emerging Issues Task Force (EITF) are faced with the task of trying to keep pace with the continuous innovations in the securitization market, and have created additional materials intended to help apply FASB 125 to a variety of circumstances.2

FAS B 1 2 5 A P P L I E S TO :

public and private companies; public and private offerings; and all transfers of nancial assets.

FAS B 1 2 5 D O E S N OT A P P LY TO :

transfers of non-nancial assets such as operating leases, servicing rights, stranded utility costs, or sales of future revenues such as entertainers royalty receipts;

investor accounting rules (but see discussion of Interest-Only strips and other securities subject to prepayment risk);

income tax sale vs. borrowing characterizations or tax gain/loss calculations; 3 regulatory accounting or risk-based capital rules for depository institutions; 4 statutory accounting or risk-based capital rules for insurance companies; 5 accounting principles outside of the United States (but FASB 125 does apply to transactions by foreign subsidiaries in consolidated nancial statements of U.S. multinationals and foreign companies that follow U.S. GAAP usually for SEC , securities lings).6

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1. This booklet addresses only securitizations. It does not address other transactions covered by FASB 125, such as repos, dollar rolls, securities lending transactions, wash sales, loan syndications, loan participations, bankers acceptances, factoring arrangements and debt extinguishments, including in-substance defeasances of debt. 2. The FASB staff has codied the status of each prior EITF consensus affected by FASB 125. This can be found in Topic D-52 of the EITF Abstracts. Also, they have prepared a Special Report, A Guide to Implementation of Statement 125, Third Edition, which contains well over 100 questions and answers (The FASB 125 Q&A Implementation Guide). 3. The Financial Asset Securitization Investment Trust (FASIT) tax legislation became effective September 1, 1997, but FASITs have not been popular vehicles and tax regulations have not yet been issued. Also see page 22. 4. Federally chartered banks are required to follow generally accepted accounting principles (i.e., FASB 125) when preparing Call Reports. However, pursuant to the risk-based capital rules, in asset sales in which the bank provides recourse, the bank generally must hold capital applicable to the full outstanding amount of the assets transferred. The low-level recourse rule limits the risk-based capital charge to the lower of (a) the banks maximum contractual exposure under the recourse obligation (e.g.,the book value of a spread account or subordinated security) or (b) the amount of capital that would have been required, had the assets not been transferred. The Ofce of the Comptroller of the Currency and the other bank regulatory agencies are currently considering the regulatory capital treatment for sales with recourse and are planning to issue a notice of proposed rule making on that subject. 5. The National Association of Insurance Commissioners (NAIC) has adopted, in Statement of Statutory Accounting Principles No. 33, the securitization guidance in FASB 125 except (a) sales treatment is not permitted for transactions where recourse provisions or call or put options exist and (b) servicing rights assets are nonadmitted assets. Recourse for these purposes does not include the retention of a subordinated class in a securitization. 6. Our rm has compiled descriptions of the accounting for securitizations in 33 countries. Excerpts are included in the 1999 Annual Database published by International Securitisation Report, and can also be obtained by contacting Frank Dubas, Deloitte Touche Tohmatsu New York, +1 212 436 4219, fdubas@dttus.com.

determining

whether

CRITERIA

SALE

the
SECURITIZATION MEETS THE

W H E N I S A S E C U R I T I Z AT I O N AC C O U N T E D F O R AS A S A L E ?

A securitization of a nancial asset, a portion of a nancial asset, or a pool of nancial assets in which the transferor (1) surrenders control over the assets transferred and (2) receives cash or other proceeds (other than benecial interests in such assets) is accounted for as a sale. The transferor is considered to have surrendered control in a securitization only if all three of the following conditions are met:

1. The transferred assets have been isolated from the transferor put beyond the reach of the

transferor, its afliates and their creditors (either by a single transaction or a series of transactions taken as a whole) even in the event of bankruptcy of the transferor. [9a and 23] 7
This is a facts and circumstances determination, which includes judgments about the kind of bankruptcy or other receivership into which a transferor or Special-Purpose Entity might be placed, whether a transfer would likely be deemed a true sale at law, and whether the transferor is afliated with the transferee. In contrast to the goingconcern convention in accounting, this possibility of bankruptcy must be dealt with, regardless of how remote it may seem in relation to the transferors current credit standing. For example, a double-A rated issuer of auto paper must take steps to isolate the assets in the event of bankruptcy and cannot simply say that there is no way that issuer bankruptcy could be a problem during the relatively short term of the securitization. Why do the assets have to be isolated? See page 15.

2. The transferee or, in a two-tier structure, the second transferee, is a qualifying special-purpose

entity (QSPE) (see denition on page 8) and the holders of debt and equity securities in that entity have the right to pledge and/or exchange those securities. If the issuing vehicle is not a qualifying SPE, then sale accounting is only permitted if the SPE itself has the right to pledge and/or exchange the transferred assets. [9b]
The qualifying status of an SPE is extremely important because, generally, a QSPE does not have to be consolidated, while a non-qualifying one may need to be consolidated. See discussion on page 10, entitled: Do QSPEs get consolidated? Note that in a two-tier structure, the entity that issues the securities (e.g., the trust) needs to be the QSPE. The intermediate SPEs (e.g., the Depositor) are typically not considered QSPEs. As long as the issuing SPE is a QSPE, the nature of the intermediate entities should not affect the accounting treatment for consolidation purposes. QSPEs are basically designed to operate on automatic pilot. Must a QSPE be brain

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dead? (See page 8.) At inception, the SPE hires a servicer (generally the transferor) to collect payments on its assets. It also hires a trustee to administer and oversee its undertakings, and may engage the services of an advisor to identify appropriate investments
7. Numbers within brackets refer to paragraph numbers of FASB 125. Shaded information is scheduled to be amended by the Exposure Draft of the proposed amendments to FASB 125. See Section 4 Whats Slated to Change in 2001.

Determining whether the securitization meets the sale criteria

for temporary excess funds. The substantive investor protection features of a highly rated securitization are designed to prevent the seller from altering signicant terms without the investors consent. Holders of an SPEs securities are sometimes limited in their ability to transfer their interests, due to a requirement to only transfer a security if an exemption from the requirements of the Securities Act of 1933 is available. The primary limitation imposed by Rule 144A, that a potential buyer must be a sophisticated investor would not preclude sale accounting if a large number of qualied buyers exist so that holders could transfer their benecial interests.

3. The transferor does not effectively maintain control over the transferred assets by an agreement

that entitles (or both entitles and obligates) the transferor to repurchase the transferred assets. [9c]
A cleanup call is permitted and is dened as: a purchase option held by the servicer, who may be the transferor, which is exercisable when the amount of outstanding assets falls to a level at which the cost of servicing those assets becomes burdensome. [243] See further discussion of cleanup calls in the next section. An agreement that both entitles and obligates the transferor to repurchase the transferred assets (e.g., an automatic rather than optional repurchase) maintains the transferors effective control over those assets and, therefore, is generally accounted for as a secured borrowing. [27] Other considerations apply if the transferred assets are readily obtainable elsewhere. Rarely are assets that are transferred in securitizations readily obtainable elsewhere.

W H AT A B O U T P U T S A N D C A L L S ?

No quantitative guidance on the size of a cleanup call is set forth in FASB 125. Ten percent of the transferred balances is generally viewed as the maximum for GAAP Note that the . denition states that the option is held by the servicer. Also, the SEC staff has said that call options on the debt or equity securities issued by the QSPE have the same effect as call options on the transferred assets. [Topic D-63 of the EITF Abstracts.] If the transferred assets are readily obtainable elsewhere (such as Treasury Bonds or widely traded corporate bonds), then a call option (regardless of size) will not disqualify sale treatment, and certain forward repurchase agreements may not give the transferor effective control. [30] The theory here is that if the assets are readily obtainable elsewhere, the transferee can sell the transferred assets (thereby relinquishing the sellers effective control), and if the call option is exercised, the buyer can readily nd suitable assets in sufcient quantity to satisfy the call. This provision does not offer much practical utility for the securitization of consumer or other types of loans (though some widely traded debt securities are readily obtainable). It is unlikely that an SPE would be permitted to sell the transferred assets and be able to buy substantially the same loans acceptable to the transferor in the event the transferor exercises its call option. Its interesting (and to some, counterintuitive) that put options held by the transferee or holders of its securities do not disqualify sale treatment (but be sure to check with legal
7

counsel, as put options complicate the true sale analysis). The FASBs theory here is that a put option is in the transferees control; therefore the seller has relinquished control, even if only temporarily. For example, convertible ARMs could be securitized with a put back to the transferor if the borrower converts. Short-term tranches could have a guaranteed nal maturity in the form of a put to achieve liquid asset treatment for thrifts or money market treatment for certain classes of investors. In each of these cases, at the sale date, the transferor would have to record as a liability the fair value of the put obligation. If it is not practicable to estimate its fair value, no gain on sale can be recorded. A very deep in the money put is the economic equivalent of a repurchase obligation. The SEC staff has pointed out the inconsistency of sale treatment and deep in the money puts. Also, asymmetrical principal distributions such as turbo features, sequential pay classes, controlled amortization or bullet payments in revolving structures can be adopted in sale transactions. However, provisions that both entitle and obligate the transferor to reacquire nonreadily obtainable assets are considered forward commitments to repurchase and do not qualify for sale treatment. These differ from a put or call option because an option is volitional. If it is disadvantageous to the buyer to exercise its put rights, the buyer lets them lapse and can sell the assets at a better price in the open market. In a forward, the buyer is obligated to perform; it must return the assets. For example, consider 5/1 ARMs in which the borrowers interest rate periodically adjusts after the initial ve-year xed rate period. If these loans were transferred for just the ve-year period, sale accounting would not be appropriate. However, a buyer put at the end of ve years would be acceptable (subject to meeting the other sale criteria).

M U ST A Q UA L I F Y I N G S P E C I A L- P U R P O S E E N T I TY B E B R A I N - D E A D ?

If it is not brain-dead, it must at least be on automatic pilot. A QSPE must meet both conditions (a) and (b) below:

a. It is a trust, corporation, or other legal vehicle whose activities are permanently limited to:
1] Holding title to the transferred assets. 2] Issuing benecial interests in the form of debt or equity securities. These include rights to receive all or portions of specied cash inows, including senior and subordinated rights to interest or principal inows to be passed through (e.g., multiclass participation certicates) or paid through (e.g., notes or bonds) and residual interests. 3] Collecting cash proceeds from assets held, reinvesting in eligible investments

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pending distribution and perhaps servicing the assets held. 4] Distributing proceeds to the holders of its benecial interests.

b. It has standing at law distinct from the transferor. If the transferor holds all of the benecial interests, the trust has no standing at law and is not distinct. Thus it is not a QSPE, and such a transaction is neither a sale nor a nancing. The true test here is whether the transferor gives up the ability to unilaterally dissolve the trust and reclaim the individual assets. [26] SPEs that issue debt or equity interests to parties unafliat-

Determining whether the securitization meets the sale criteria

ed with the transferor usually meet the condition of having standing at law distinct from the transferor because the transferor may not dissolve the entity without any involvement by the third-party holders of the benecial interests. Some say a QSPE is not allowed to think. As noted above, a QSPE may service its assets. While these activities may require management involvement, they involve support and not trading activities and, thus, are permitted. A QSPE is also limited to holding only nancial assets. Therefore, any SPE holding nonnancial assets, such as unguaranteed residual values in direct nancing leases, would not be considered a QSPE. A QSPE may temporarily hold nonnancial assets as a result of foreclosing on nancial assets (e.g., repossessed autos). FASB 125 does not address whether a QSPE is permitted to hold derivatives. However, the FASB staff addressed this issue in the FASB 125 Q&A Implementation Guide (questions 2527). A QSPE may hold derivatives if they are entered into by the QSPE at the inception of the QSPE or when the QSPE issues benecial interests. Another key consideration: the derivative position cannot cause the transfer to fail the sale conditions of FASB 125, including the requirement that the assets are legally isolated and the requirement that the transferor surrender effective control. Finally, the derivative position cannot have the potential to cause the QSPE to fail any of the criteria established by EITF Topic D-66 (see page 19). An example of a derivative entered into by an SPE is an interest rate swap. If the SPE has xed rate assets and issues variable rate benecial interests, the entity may enter into a pay xed/receive variable interest rate swap with the transferor or a third party at the inception of the transfer to provide protection to investors against changes in interest rates. Provided the swap was entered into concurrently with the purchase of nancial assets or the issuance of benecial interests, the swap would not preclude the entity from being a QSPE. Derivatives entered into between the transferor or an afliate and the securitization vehicle require special scrutiny because they could cause a lawyer to conclude that legal isolation is not met. While interest rate swaps, xing an interest rate mismatch between the assets and the benecial interests are not uncommon, a total return swap may preclude counsel from rendering an appropriate true sale opinion.8 Some derivative strategies require active management (e.g. using futures and options to hedge the prepayment risk of a mortgage portfolio). Again, such strategies warrant special scrutiny. It is doubtful that all of the derivatives could be entered into only at inception or upon issuance of benecial interests. Also, because derivatives are rarely perfect hedges of the
8. Although their terms differ, some total return swaps result in an afliate of the transferor retaining all of the risks inherent in the assets. As a result, the benecial interest holders return is predicated only on the credit worthiness of the transferors afliate rather than on the performance of the securitized assets.

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exposure they are designed to manage, it may be difcult to discern whether the positions are managed solely in an effort to reduce risk or, perhaps, with an eye to generating prots. The latter motivation is inconsistent with the restrictions on QSPEs so-called trading for gains.

As noted above, activities of a QSPE include issuing benecial interests. There is no requirement that all of these interests be issued at the same time. Future issuances or rollover of benecial interests would not preclude an SPE from being considered qualifying if the future issuances are permitted under the governing trust documents, the future issuances occur automatically, and the issuer is not entitled to reacquire the assets.

D O Q S P E S G E T C O N S O L I DAT E D ?

FASB 125 does not provide any guidance on consolidation of SPEs. The FASB had hoped to issue a new accounting standard on consolidation simultaneously with FASB 125, but was unable to do so.9 The off-balance sheet goal of a securitization would be defeated if the securitizer is required to consolidate the accounts of the SPE to which the assets are ultimately transferred, particularly if the SPE has issued debt securities. For example, consider the transaction in which you structure a securitization that clearly meets all three criteria for a sale, using a qualifying wholly-owned SPE that issues debt and equity interests, and then proceed to consolidate the SPE. The transferred assets re-emerge on the balance sheet. Contrast this with simply accounting for the retained interests in the securitization (in form, often equity interests in the SPE) as a residual nancial asset. Fortunately, the EITF addressed this issue. In Issue 96-20, they reached the following consensus.

If the SPE:
1] meets all of the conditions of paragraph 26 of FASB 125 to be a QSPE; (see page 8) 2] holds only nancial assets such as receivables from credit cards, mortgage loans or securities that represent a contractual right to cash (or another nancial instrument) from, or an ownership interest in, an entity that is unrelated to the transferor; 3] does not undertake a transaction (or a series of transactions) that has the effect of (a) converting nonnancial assets, for example, real estate or servicing assets, into a nancial asset or (b) recognizing a previously unrecognized nancial asset, for example, an operating lease; then the transferor has surrendered control over the nancial assets, and consolidation is not appropriate regardless of whether the SPE is wholly owned or whether it has any equity.
9. The FASB has proposed a Statement on Consolidations Policy, which is scheduled to be nalized in the second quarter of 2000. The current version does not provide much guidance on consolidation of securitization SPEs. It is possible that, under this new standard, sponsors of non-majority owned SPEs will be deemed to control the SPE and therefore be required to consolidate the nancial statements of the SPE with the sponsors own nancial statements. Given the limited activities of SPEs and other features of securitizations, it is reasonable to expect that many sponsors will be able to demonstrate that they do not control SPEs. However, this is a fact-intensive determination that will have to be carried out individually for each SPE, and it is impossible to say at this time how the control test will be interpreted in various circumstances. Stay tuned for further developments.

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Determining whether the securitization meets the sale criteria

W H AT I F T H E I S S U E R I S N OT A Q S P E ?

If the securitization vehicle fails to meet QSPE criteria (for example, it buys and sells securities for its portfolio of pledged collateral), the sponsor, creator or transferor needs to determine whether it must consolidate the entity using the following accounting guidance:

If the sponsor, creator, transferor or third party investor owns the majority of the equity and voting rights, and the entity is signicantly capitalized then the entity should be consolidated by that majority owner pursuant to ARB 51 and FASB 94

If the entity is nominally capitalized (see below), then regardless of who nominally owns the majority of the equity and voting rights, the sponsor, creator or transferor needs to look to the consolidation criteria of EITF Abstracts, Topic D-14, and by analogy, EITF 90-15, 96-16, 96-20 and 96-21 to determine whether the SPE should be consolidated.

When the securitization vehicle is not a QSPE, EITF Topic D-14 and related EITF topics require an initial (and ongoing) substantive (e.g. 3%) residual equity capital investment, held by third party investors who control the majority of the equity and voting rights. Securities in the form of equity often have less investor appeal compared to debt securities. For example, internal policy or external regulation may preclude many potential investors from investing in equity securities. As a result, many deals such as CBOs have been structured with the substantive capital investment taking the form of subordinated debt. However, the SEC staff has said legal form is critical. A third party investment that takes the form of debt, regardless of the degree of its subordination or its economic similarity to equity, will not qualify for the 3% test The Chief Accountant of the SEC and members of his staff reit. erated this point in speeches during the closing months of 1999, asserting that they would require consolidation of the non qualifying SPE by the sponsor in those circumstances.

I S I T P O S S I B L E TO ST R U C T U R E D E B T- F O R - TA X AS A S A L E F O R G A A P ?

We nd that the securitization term debt-for-tax means different things to different people. In its most advanced state, the securitizer seeks to meet all of the following objectives, not simply the rst one: 1] The securities being issued are characterized as debt of the Issuer rather than equity in an entity, in order to avoid double taxation. 2] The transaction is treated as a nancing by the transferor for tax purposes. This is accomplished by including the assets and debt of the Issuer in a consolidated tax return of the transferor, which results in deferring an up-front tax on any economic gain realized in the securitization. Note that in the case of mortgage loans, REMIC transactions are, by denition, a sale for tax purposes to the extent the sponsor disposes of the regular and/or residual interests.

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3] Notes or Bonds rather than Pass-Through Certicates are issued so as to invite easier participation and eligibility for certain categories of investors such as Employee Retirement Income Security Act (ERISA) plans. 4] The transaction is treated as an off-balance sheet sale for accounting purposes with recognition of any attendant gain and without consolidation of the Issuer into the nancial statements of the transferor. To meet that accounting objective, we suggest you follow the following guidelines: 1] The issuer needs to be a QSPE (see page 8). Note that in a two-tier structure, the entity that issues the debt (e.g., the owner trust) needs to be the QSPE. The intermediate SPEs (e.g., the Depositor) are typically not considered QSPEs. As long as the issuing SPE is a QSPE, the nature of the intermediate entities should not affect the accounting treatment for consolidation purposes. 2] The legal form of the QSPE does not matter for accounting purposes so long as it has distinct standing at law. It can be an owner trust, partnership, corporation, etc. 3] There is no minimum size requirement for the equity of the QSPE for accounting purposes, but check with your tax advisors. 4] The equity of the QSPE can be wholly owned by the transferor. 5] The assets transferred to the QSPE must all be nancial assets. 6] The transfer of assets to the QSPE must meet the sale accounting requirements of FASB 125. The critical factor here is that the lawyers will be asked to give a would opinion on the question of isolation of assets in the event of bankruptcy of the transferor or its afliates. 7] Put options may be okay if the bankruptcy lawyers say they are okay (see item 6 above). 8] Call options are problematic. Generally, the Issuer and the tax lawyers want substantive call provisions and the accountants and underwriters do not. The Chief Accountant of the SEC announced that call options on the bonds should be viewed the same way as call options on the transferred assets; that is, the use of such call options would be considered inconsistent with the sale accounting requirements of FASB 125, [Topic D-63 of the EITF Abstracts]. In practice, a safe harbor has emerged at the 10 percent of transferred assets level to qualify as a cleanup call provided the transferor or an afliate is the servicer and holds the cleanup call. The fact that QSPEs are no longer consolidated for GAAP has somewhat reduced the tension that often existed between accountants and tax professionals when trying to structure a debt-for-tax/sale-for-GAAP deal. It has also allowed for the issuance of collateralized

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debt securities by QSPEs rather than some form of hybrid debt/participation certicate. Tax practitioners generally take into consideration the following factors in determining whether a transaction should be treated as a nancing, and some of the factors are given greater weight than others: 1] A revolving period of at least one year or a partial reinvestment of principal collections in newly originated collateral for at least three years;

Determining whether the securitization meets the sale criteria

2] Payment mismatch (e.g., monthly pay collateral vs. quarterly pay debt); 3] Use of excess spread to pay principal on debt so that the debt can be retired before the collateral is repaid; 4] Existence and the size of the present value of the equity in the issuing entity; 5] Nomenclature used in the transaction (i.e., labeling the securities as bonds or notes); 6] Interest rate cap (i.e., a debt-like cap at an objective rate or an equity-like cap at the weighted average rate of the loans); 7] Right of the Issuer to call the debt at a point signicantly earlier than a typical cleanup call (see previous warning for GAAP sale treatment); 8] Use of a oating rate index for interest on the debt different than the index on the underlying loans.

C A N WA R E H O U S E F U N D I N G A R R A N G E M E N T S B E O F F- B A L A N C E S H E E T ?

One ingredient for a successful securitization is adequate deal size securitizing a pool of assets that has reached critical mass. If the deal is sufciently large, the costs of developing the structure and paying advisors, underwriters, ongoing administrators and trustees are typically more economical in relation to the amount of capital raised. Also, large deals attract a larger pool of investors and enhance the name recognition of the securitizer. Traditionally, a securitizer of longer-term assets accumulates (or warehouses) these assets on its balance sheet. When the pool reaches critical mass, the loans are sold in a typical term securitization. During the accumulation phase, the securitizer nances the cost of carrying the assets with prearranged lines of credit, known as warehouse or repo lines. Typically, the securitizer hedges the price risk of loans in the warehouse as they await sale. The loans are often securitized near quarter-end to assure that the on-balance sheet shortterm funding can be retired, so as not to violate debt covenants that might exist. There are disadvantages to the traditional warehouse approach. Because so many securitizers sell assets close to quarter-end, the supply concentration could widen securitization spreads. Also, market participants fear that an unexpected, large disruption in the capital markets could temporarily preclude securitizers from timely access to needed funds. Finally, if a securitizer is unable to execute a securitization on schedule, equity analysts would likely demand explanations for the delay and for the absence of securitization income that quarter. An off-balance sheet warehouse securitization offers a partial solution to these problems. But these structuresoffered in a variety of avorsneed careful accounting scrutiny to comply with the off-balance sheet criteria of FASB 125 and related EITF guidance while preserving debt treatment for tax. In an off-balance sheet warehouse, a commercial or investment bank typically purchases a class of benecial interest issued by a securitization vehicle created by the seller. Using the proceeds from the sale of the benecial interest, the vehicle acquires loans from the secu-

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ritizer as they are originated. The benecial interest takes the form of a variable funding note, whose principal adjusts upward, to a ceiling, as the securitizer transfers additional loans to the vehicle. The seller retains a benecial interest that entitles it to all cash ows on the loans not needed to service or credit enhance the variable funding note. When the transferred assets have reached critical mass and market conditions are judged appropriate, the holder of the variable funding note puts it back to the vehicle, forcing the entity to dispose of the assets to raise cash to redeem the note. Properly structured, puts such as these comply with the sale criteria of FASB 125 and do not disqualify the entity from being a QSPE. Sometimes, the seller bids on the assets in a bona de auction and, if successful, reacquires the assets and sells them again in a term securitization.10 See page 19 for a description and limitations on the powers of a QSPE under EITF D-66. What triggers the investment banks desire to put its interest? Presumably, the investment bank and the securitizer have ongoing discussions regarding the state of the securitization markets, the securitizers preference for a term securitization, and the investment banks desire to earn fees associated with underwriting the term deal. Also, most investment banks do not have the appetite for long-term investments with the characteristics of the variable funding note. All of these factors plus a desire for an ongoing relationship with the securitizer suggest that the investment bank would look favorably upon a suggestion to put their interests. The fact remains that there cannot be a contractual obligation or a direct or indirect nancial compulsion that effectively forces the investment bank to exercise the put. Bottom line the securitizer places signicant trust in its investment banker in order to achieve off-balance sheet accounting. If the warehouse securitization structure complies with all of the off-balance sheet sale conditions of FASB 125 and related EITF guidance, the securitizer recognizes a book gain or loss on the transfer but typically not a tax gain or loss. Gain or loss is calculated conventionally, but without anticipating any of the benets that might arise in a subsequent term securitization of the assets, and based solely on the terms of the warehouse arrangement. As a practical matter, one should be skeptical of any gain calculation that produces a gain in excess of the gain that could have been obtained had the securitizer sold the loans outright in a whole loan sale without any continuing involvement beyond conventional servicing. Why? Fundamentally, the life of a warehouse securitization is much shorter compared to a term transaction, but its actual duration is difcult to predict. This complicates the estimate of the relative fair value of the retained interests. Also, a term securitization

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often takes advantage of arbitrage opportunities, typically by using a multi-class structure designed to satisfy the narrow appetites of different investor classes. Because the securitizer cannot record this benet until a term securitization takes place, any gain on a warehouse deal would be relatively smaller.
10. Note that D-66 deals with a securitizers participation in an auction process. Included in this guidance is the observation that a recurring pattern of reacquisitions can suggest the existence of a prohibited call option.

Determining whether the securitization meets the sale criteria

C A N I C O N V E RT LOA N S TO S E C U R I T I E S O N M Y B A L A N C E S H E E T ?

For liquidity purposes, state tax planning, capital requirements or other reasons, nancial institutions might wish to convert whole loans to one or more classes of securities at least in the near term. Because no proceeds are raised, these transactions are neither a sale nor a nancing under FASB 125. At the time of this writing, the FASB is working on a Technical Bulletin which concludes that if the conversion was accomplished through an SPE that is not a QSPE, then the transferor should account for the transferred nancial assets in its consolidated nancial statements in accordance with their form prior to the transfer because the securities held and issued would be eliminated in the consolidated nancial statements. On the other hand, if a non-consolidated QSPE is used, the assets would be accounted for in the transferors consolidated nancial statements as debt securities with no gain or loss recognized unless the securities are classied as trading. Stay tuned for further FASB Technical Bulletin developments.
W H Y D O T H E AS S E T S H AV E TO B E I S O L AT E D ?

While the benets of asset isolation are no doubt laudatory, why has the FASB incorporated this notion as a condition for sale accounting? The Board explains its decision as follows: Credit rating agencies and investors pay close attention to the possibility of bankruptcy of the transferor, its afliates or the special-purpose entity, even though the possibility may seem unlikely, because those are major risks to them. If receivers can reclaim securitized assets, investors will suffer a delay in payments due them, and may be forced to attempt a pro rata settlement. Credit rating agencies and investors commonly demand transaction structures to minimize those possibilities. They also seek assurances from attorneys about whether entities can be forced into receivership, what the powers of the receiver might be, and whether the transaction structure would withstand receivers attempts to reach the securitized assets in ways that would harm investors. Unsatisfactory structures or assurances could result in credit ratings that are lower than those of the transferors liabilities, and in lower prices for transferred assets. [118] Many securitizations use two transfers to isolate transferred assets beyond the reach of the transferor and its creditors: STEP 1: The corporation transfers assets to a Special-Purpose Corporation (SPC) that, although wholly owned, is designed so that the chance of the transferor, or its creditors, reclaiming the assets is remote. The rst transfer is designed to be judged a true sale at law, in part because it does not provide credit or yield protection. STEP 2: The SPC transfers the assets to a trust, with a sufcient increase in the credit and yield protection on the second transfer, 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 SPC. However, the SPCs charter forbids it from

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undertaking any other business or incurring any liabilities, so that there can be no creditors (other than any arising from the securitization itself) to petition to place it in bankruptcy. Accordingly, the SPC is designed to lessen the possibility that it would enter bankruptcy, either by itself or as part of a bankruptcy of its parent. [57] A one-tier structure with signicant continuing involvement by the transferor might not satisfy the isolation test. A trustee in bankruptcy of the transferor might nd the transfer to not be a true sale in such circumstances, and has substantial powers to alter amounts that investors might receive. Generally, the standard for isolation of assets would be met if it is concluded that: 1] The transfer from the originator to the subsidiary SPC constitutes a true sale; 2] The SPC, on one hand, and its afliates that are not SPCs, on the other hand, would not be substantively consolidated in the case of the bankruptcy of any such applicable afliate; and 3] The nal transfer from the consolidated group is either a true sale or the transfer of a rst priority, perfected security interest in the transferred assets. Do I always need a lawyers letter? (See page 17.) Any company or subsidiary regardless of location that prepares nancial statements in accordance with U.S. GAAP must adequately isolate securitized assets (and meet the other conditions of FASB 125) to achieve sale accounting. Whether assets have been isolated will depend on an evaluation of laws in the jurisdiction governing the transaction. The advice of counsel familiar with local laws is especially important.

D O B A N K S H AV E TO I S O L AT E T H E I R AS S E T S TO G E T S A L E T R E AT M E N T ?

Banks are not subject to the U.S. bankruptcy code. Right now, banks are operating in a kind of GAAP limbo. FASB 125 indicates that the powers of the Federal Deposit Insurance Corporation (FDIC), acting as a receiver for a failed nancial institution, are in synch with the FASBs notion of legal isolation. But FASB 125 mischaracterized and underestimated the agencys real powers. While the proposed amendment to FASB 125 clears up the misunderstanding, it does not revise the general criterion for legal isolation or make it any easier to meet. A FASB staff announcement (EITF Abstracts, Topic D-67) currently lets banks satisfy the legal isolation criterion by permitting them to rely on FASB 125 as originally written, but only until the proposed amendment is effective.

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In September 1999, the FDIC issued a proposed rule designed to help banks continue to meet the GAAP requirements. The proposed rule states: The FDIC shall not, by exercise of its authority to disafrm or repudiate contracts, reclaim, recover or recharacterize as property of the institutionany nancial asset

Determining whether the securitization meets the sale criteria

transferred by an insured depository institution in connection with a securitization or participation, provided that such transfer meets all conditions for sale accounting under generally accepted accounting principles, other than the legal isolation condition, which is addressed by this section. Lawyers will have to evaluate whether the FDICs proposed rule places them in a position to issue a would opinion on whether the transferred assets would be beyond the reach of the FDIC and the banks other creditors, even in the event that the bank was placed in receivership. Banks do retain one advantage. Under the FDICs proposed rule, although the securitization must be issued by an SPE, a two-tier structure (with an intermediate bankruptcy remote entity) does not appear to be needed.

D O I A LWAYS N E E D A L AW Y E R S L E TT E R ?

In late 1997, the American Institute of Certied Public Accountants issued an interpretation of generally accepted auditing standards,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. 125. The interpretation contains an extract of a legal opinion (for an entity that is subject to the U.S. Bankruptcy Code), which provides persuasive evidence (in the absence of contradictory evidence) to support managements assertion that the transferred assets have been isolated. In short, it is a true sale would opinion vs. a should or more likely than not opinion. 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 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 afliate of the Seller has also entered into transactions with the Purchaser, the opinion should address that.]

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The previous example deals with a one-step transfer of nancial assets. In a two-step transfer, a lawyers opinion should also address the second transfer (from the wholly-owned bankruptcy remote subsidiary to the securitization vehicle that issues benecial interests to investors). In most securitizations that feature credit enhancement (for example, the whollyowned bankruptcy remote subsidiary retains a subordinated interest in the securitization vehicle), the lawyers letter usually cannot conclude that the second transfer is a true sale. Instead, the attorney usually concludes that this transfer would either be a true sale or a secured nancing and that is acceptable. Other issues covered in the auditing interpretation:
QUESTIONS KEY POINTS

What should the auditor consider in determining whether to use a lawyer to obtain persuasive evidence to support managements assertion that a transfer of assets meets the isolation criterion of FASB 125?

Use of a lawyer may not be necessary when there is a routine transfer of nancial assets without continuing involvement by the seller (e.g., full or limited recourse, servicing, other retained interests in the transferred assets or an equity interest in the transferee). 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 difcult 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 lawyer may be a clients internal or external attorney who is knowledgeable about relevant sections of the law. The auditor should consider whether the lawyer has experience with relevant matters, such as knowledge of the U.S. Bankruptcy Code and other applicable foreign or domestic laws and knowledge of the transaction. 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.

If the auditor determines that the use of a lawyer is required, what should he or she consider in assessing the adequacy of the legal opinion?

Are legal opinions that restrict the use of the opinion to the client or to third parties other than the auditor acceptable audit evidence? If the auditor determines that it is appropriate to use the work of a lawyer, and either the resulting legal response does not provide persuasive evidence...or the lawyer does not grant permission for the auditor to use a legal opinion that is restricted..., what other steps might an auditor consider?

No. The auditor should request that the client obtain the lawyers written permission for the auditor to use the opinion. Language to the effect that the auditors are authorized to use but not rely on the lawyers letter is not acceptable audit evidence.

Because isolation is assessed primarily from a legal perspective, the auditor usually will not be able to obtain persuasive evidence in a form other than a legal opinion. In the absence of persuasive evidence, sales accounting is not in conformity with GAAP, and the auditor should consider the need to modify the auditors report on the nancial statements.

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Determining whether the securitization meets the sale criteria

The interpretion does not currently apply to securitizations by FDIC-insured institutions, but Do banks have to isolate their assets to get sale treatment? (See page 16.)

C A N A Q S P E E V E R S E L L I T S AS S E T S ?

The FASB staff provided guidance on the powers of a QSPE in an announcement at the January 1998 EITF meeting (documented in Topic D-66 of the EITF Abstracts). Topic D-66 addresses the effect of an SPEs powers to sell, exchange, repledge or distribute transferred nancial assets (collectively these are referred to below as the powers of a QSPE). Topic D-66 allows an SPE to exercise a power to sell, exchange, repledge or distribute transferred nancial assets in response to a cleanup call or if all of four stipulated conditions exist. As will be seen, the conditions prevent a securitizer from transferring off balance sheet all or a portion of its managed investment or trading portfolio. The conditions also block an end run around FASB 125s prohibition on achieving sale accounting when the seller has effective control over the transferred assets. The four conditions follow and theTopic D-66 examples are included in the accompanying table. 1] The powers and the conditions or events that permit them to be exercised are specied in and lim-

ited permanently by the legal documents that (a) establish the SPE or (b) initially create the benecial interests in the transferred assets that are subject to the powers.
2] The powers do not result in the transferor or its afliates maintaining effective control over the

transferred assets or over the sale of those assets.

3] The primary objective of the powers is not to realize a gain in the fair value of the transferred

assets above their fair value at the time they were transferred to the SPE. Also, those powers do not permit the transferor, its afliates or the SPE the discretion to sell transferred assets to maximize the return to all or some of the benecial interest holders. This condition does not preclude benecial interest holders other than the transferor and its afliates from having the ability to put their benecial interests back to the SPE and, thereby, trigger the sale or distribution of assets.
4] The powers do not permit active or frequent selling and buying of assets. Under the FASB staffs guidance, an SPE is not qualifying if it can sell instruments in which cash reserves are reinvested for purposes of realizing a gain or otherwise maximizing the return to some portion of the benecial interest holders. Also not qualifying is an SPE that is empowered to actively manage its temporarily invested cash reserves by selling and reinvesting. Note that the staffs interpretation does not limit the type of instruments in which to reinvest temporary cash.

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EXAMPLE: An SPE has cash balances that will not be distributed to beneficial interest holders for 200

days. The documents that establish the SPE give it the discretion, in these circumstances, to choose between investing in commercial paper obligations that mature in either 90 or 180 days. This discretion does not preclude the SPE from being qualifying. If, in these circumstances, the SPE also has the discretion to invest in 360-day commercial paper with the intent to sell it in 200 days, the SPE is not qualifying.
Limited powers of a QSPE specied in the original governing documents Powers that enable the SPE to sell its assets or put them back to the transferor
EXAMPLES CONSISTENT WITH QSPE STATUS EXAMPLES INCONSISTENT WITH QSPE STATUS

The SPE has the power to either (1)put the transferred assets back to the transferor or (2) sell those assets in response to (a) a default by the obligor, (b) a major thirdparty rating agency downgrade of the transferred assets or the underlying obligor to a rating below a specied minimum rating, or (c) a decline in the fair value of the transferred assets to a value signicantly less than their fair value at the time they were transferred to the SPE. The SPE has the power to sell transferred assets (or to put transferred assets to the servicer, to a third party or back to the transferor) in response to a failure by the transferor to properly service transferred assets that could result in the loss of a substantial third-party credit guaranty.

The transferor has the power, either directly or indirectly, to trigger a condition that enables an SPE to sell the transferred assets (unless the triggering of the condition would have a signicant adverse consequence to the transferor).

The SPE is required to return transferred assets back to the transferor upon the occurrence of an event that at the time of the initial transfer is probable to occur (unless that transfer back would result in signicant adverse consequences to the transferor).

The SPE has the power to sell transferred assets in response to a transferors decision to exit a market or a particular activity. The SPE has the power to sell transferred assets in response to the transferor violating a nonsubstantive contractual provision. The benecial interest holders in an SPE other than the transferor may put their benecial interests in the transferred assets back to the SPE in exchange for (1) a full or partial distribution of those assets, (2) cash (which may require that the SPE sell those assets to the transferor or a third party or issue benecial interests to comply with the put), or (3) new benecial interests in those assets. The SPE is obligated to sell transferred assets under an option contract written by the SPE that entitles parties other than the third-party benecial interest holders to call those assets and, under that arrangement, permits the SPE to trigger a sale and effectively recognize an appreciation in the fair value of the transferred assets.

Auction sales The SPEs original legal documents schedule a sale or an auction of the transferred assets at the end of the life of either the SPE or the benecial interests in the transferred assets; the transferor is precluded from bidding an amount above fair value for the transferred assets, and the sale or auction includes obtaining bona de offers from participants other than the transferor. However, a pattern of the transferor obtaining transferred assets through scheduled sales or auctions would suggest that it is bidding amounts greater than fair value and, therefore, maintaining effective control over the transferred assets. The SPEs original legal documents schedule a sale or an auction of the transferred assets at the end of the life of either the SPE or the benecial interests in the transferred assets, and the transferor (1) is not precluded from bidding an amount higher than fair value and (2) retains the residual interest in an SPE, entitling it to receive all of the resulting gain from the sale of transferred assets.

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Determining whether the securitization meets the sale criteria

W H AT I F T H E T R A N S F E R D O E S N OT Q UA L I F Y AS A S A L E ?

If the transfer does not qualify as a sale, the proceeds raised (other than retained benecial interests) will be accounted for as a secured borrowing, with no gain or loss recognized, and the assets or securities will remain on the balance sheet. [12] Can I Elect Not to Recognize Gain on Sale? (See page 25.)

Even accounting for a securitization as a nancing requires the use of many subjective judgments and estimates and could still cause volatility in earnings due to the usual factors of prepayments and credit losses. After all, the company still effectively owns a residual even though you cannot nd it on the balance sheet. It is the excess of the securitized assets over the associated debt. Different accounting treatments will apply from origination through securitization and continue through maturity. Some of these differences are listed below: a] In the nancing scenario, the decision on what origination costs should be appropriately deferred under FASB 91 rather than expensed takes on added signicance in the rst year income statement, since these costs will remain deferred (amortized over the life of the loan) rather than effectively reversed within a short time frame in a gain-onsale calculation. The pace of amortization will be affected by prepayments and prepayment estimates. On the other hand, the amount of points or origination fees and premiums paid to purchase loans takes on less rst year income statement signicance since they will be spread over a long period of time rather than effectively recognized almost immediately in a gain on sale calculation. b] When mortgage loans are originated or acquired with the intent to securitize as a nancing, then the loans generally will be classied as held for long-term investment and will not be subject to a FASB 65 lower of cost or market (LOCOM) adjustment (e.g., from rising interest rates) during the accumulation period. A company might want to reconsider its hedging policies during that period because the income statement risk of a LOCOM adjustment or a lower gain on sale (e.g., if spreads widen) is mitigated. But before revising hedging strategies, remember that the economic risk associated with volatile interest rates preceding a term securitization is present regardless of the accounting treatment. c] If loans are securitized, and the securitizer retains all of the resulting securities and classies them as debt securities held to maturity under FASB 115, the securitizer does not have to recognize a separate servicing asset. That is, the servicing asset can remain embodied in the carrying value of the debt securities. If a servicing asset is created, it will be subject to LOCOM accounting under FASB 125. d] Underwriting fees and deal costs of issuance will be deferred and amortized over the life of the bonds, and the pace of amortization will be affected by prepayments.

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e] Provisions for credit losses will be made periodically under FASB 5, rather than initially estimating all credit losses over the entire life of the loans transferred and providing for them in the gain on sale calculation. f] Original Issue Discount (OID) on bond classes will be amortized as additional interest expense and the pace of amortization will be affected by prepayments. Also, in a deal with maturity tranching, especially in a steep yield curve, signicant amounts of phantom GAAP income could result. Assume, for instance, that four sequential pay tranches are issued at yields of 7%, 8%, 9%, and 10%, respectively and backed by a pool of newly-originated 10% loans. An overall yield-to-maturity on the assets is calculated and used for FASB 91 purposes, but interest expense on the bonds is calculated based on the yield to maturity of each outstanding bond. The result is that the net interest margin reported in the earlier years will exceed the net interest margin reported in the later years. Observe that, in this example, there would be no income reported during the years in which only the last class is outstanding. A more conservative answer, but perhaps not GAAP would result , if the four bond classes were treated as a single large bond class, with a single weighted average yield to maturity used to record the interest cost. g] In Real Estate Mortgage Investment Conduit (REMIC) deals, which by denition are a sale for tax purposes to the extent that the regular and/or residual interests are disposed of, taxes will still have to be paid on any up-front tax gain, and a deferred tax asset will be created for taxable income recognized before book income. When a company is willing to account for its transactions as on-balance sheet nancings, it can take advantage of certain features of the FASIT legislation that would have been in conict with sale accounting treatment. In particular, the liberal substitution and permitted withdrawals of assets when overcollateralized, and the ability to liquidate a class of securities and to hedge certain risks (all permitted for FASITs), can be used to give an Issuer signicantly more exibility than is available with REMIC structures. This does nothing, however, to mitigate the showstopper in FASITs the up front toll charge tax on an articially calculated gain.

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Determining whether the securitization meets the sale criteria

A N D I F I T D O E S Q UA L I F Y AS A S A L E ?

Gain on sale accounting (as it is sometimes described in practice) or loss on sale is not elective. It is inappropriate for the transferor to defer any portion of a resulting gain or loss. See discussion below if it is not practicable to estimate the fair value of assets obtained or liabilities incurred. If the transfer qualies as a sale, then: 1] Allocate the previous book carrying amount (net of loss reserves, if any) between the assets sold and the retained interests, if any, based on their relative fair values on the date of transfer. Allocation effectively defers a portion of the prot or loss the amount attributable to the portion(s) of the nancial asset retained. 2] Adjust the net cash proceeds received in the exchange by recording, on the balance sheet, the fair value of any guarantees, recourse obligations or derivatives such as put options written, forward commitments, interest rate or foreign currency swaps. See FASB 133, Accounting for Derivative Instruments and Hedging Activities, regarding the continuing accounting for derivatives. 3] Recognize gain or loss only on the assets sold. 4] Continue to carry on the balance sheet (initially at its allocated book value [see step 1]) any retained interest in the transferred assets, including a servicing asset, benecial debt or equity instruments in the SPE or retained undivided interests. [10,11] There is no provision that the amount of gain recognized on a partial sale cannot exceed the gain that would be recognized if the entire asset was sold. The FASB indicated that imposing such a limitation would have, among other things, resulted in ignoring the added value (i.e., arbitrage) that many believe is created when assets are divided into their several parts. [214]

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QUESTIONS
RELATED TO DETERMINING GAIN

or
LOSS

on
SALE

Questions related to determining gain or loss on sale

C A N I E L E C T N OT TO R E C O G N I Z E G A I N O N S A L E ?

More and more, securitizers are announcing that they will discontinue the use of gain on sale accounting. This is in reaction to the:

unwanted volatility in earnings that goes hand in hand with the timing of securitization transactions

vocal criticism (from equity analysts, in particular) that characterizes this accounting as front-ending income

rating agencies adding the securitization back to the balance sheet when considering capital adequacy.

The following discussion covers some of the accounting issues that a company should consider before making a switch. 1 ] The FASB and SEC staffs (EITF D-69) have determined that gain (or loss) on sale accounting is not elective in a securitization that is accounted for as a sale. In other words, prepayment, loss or discount rate assumptions may not be tailored so as to force a zero gain. 2 ] In order to report zero up-front gain, the securitization must therefore be structured as a nancing rather than a sale in virtually every case. However, one technical exception exists in the following structure and fact pattern: Assume that the securitizer issues a limited guarantee as credit enhancement for some or all of the bonds.11 Paragraph 45 of FASB 125 indicates that, if it is not practicable to estimate the fair value of a liability, then the unknown liability should be recorded as the greater of: (1) the sum of the known assets less the fair value of the known liabilitiesi.e., plug the amount that results in no gain or loss; (Paragraph 46 [Case No. 2] in FASB 125 illustrates that accounting) or, (2) the FASB 5 liability (which may be zero). As a practical matter, little guidance exists as to when it is not practicable to estimate the fair value of liabilities, and a frequent securitizer would likely resist having to disclose an inabil ity to evaluate the creditworthiness of the pool. Moreover, FASB 125 does not give guidance on the subsequent accounting under this option leaving any number of unresolved questions. For example, is income not to be recognized at all until it becomes practicable to estimate the fair value of the liability? And is income then to be recognized in one lump sum? If it is not practicable to estimate the fair value of an asset (such as a residual interest), FASB 125 calls for the asset to be recorded at no value. Adherence to this accounting will usually result in a loss on sale (even in par executions) after recognizing the out-of-pocket costs of the securitization and the premiums paid to acquire loans or costs incurred to originate them.
11. In this booklet, the term bonds also includes pass-through certicates. Both are considered benecial interests in an SPE in FASB 125 parlance.

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3] In circumstances other than the above, then, debt-for-GAAP seems to be the only practical structure. Management usually has a strong objection to this nancing treatment, due to the resulting ballooning of the balance sheet and the negative implications that this accounting has on debt/equity ratios, return on assets, debt covenant compliance, etc. It should be borne in mind, however, that the balance sheet does not balloon further if all cash securitization proceeds are used to repay on-balance-sheet warehouse funding or other debt. On the other hand, the typical pattern of a frequent securitizer today is to keep on-balance-sheet warehouse funding to a minimum as of quarterly balance sheet dates and to employ sale accounting as the means used to shrink the balance sheet debt. 4] Before issuing FASB 125, the FASB considered, but rejected, the UK approach of a linked presentation, in which the pledged assets remain on the balance sheet, but the sales proceeds (non-recourse collateralized debt) are reported as a deduction from the pledged assets rather than as a liability, and no gain or loss is recognized. We think it is time for the FASB to reconsider that approach as a means to resolve many of the thorny conceptual dilemmas that they are struggling with. 5] The most common way of intentionally achieving debt-for-GAAP is by inserting a call option that is not just a cleanup call. While no quantitative guidance exists on the maximum size of a cleanup call, 10% of the transferred assets has always been the norm. FASB 125 provides for a not too user-friendly denition of a cleanup call as occurring when the amount of outstanding assets falls to a level at which the cost of servicing those assets becomes burdensome. The FASB considered, but rejected, the sugges tion that a transaction with (for example) a 30% call should be accounted for as a 70% sale and a 30% nancing. 6] Investors sometimes object to buying or paying full value for a bond (particularly a xed-rate bond) subject to a signicant call provision. This could perhaps be mitigated by setting the exercise price for the call at a premium, which should not affect the nancing vs. sale determination under FASB 125 (unless the call is so far out of the money as to lack substance). 7] Other terms or conditions that would cause a securitization to be accounted for as debt-for-GAAP include:

A call of any size (even 1%) if the transferor is not also the servicer. Oddly enough, this is what the FASB 125 Q&A Implementation Guide states. This conclusion, however, is slated to be overturned in the planned FASB 125 amendment.

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Use of a wholly-owned SPE as the issuer of secured debt, if the SPE has been granted certain powers to sell its assets or enter into derivative contracts that disqualify it from being a QSPE under EITF D-66. (Such a grant would cause the SPE

Questions related to determining gain or loss on sale

to be consolidated pursuant to EITF 96-20.) Nothing has to last forever. If you later decide to sell at least one-half of the residual (i.e. the SPE equity), and the outside investors have made more than a nominal investment, you can deconsolidate at that time and recognize gain or loss.

Some unusual structural nuance that precludes counsel from issuing a would opinion, allowing only a true-sale should opinion.

Transferring

non-nancial assets to the issuing SPE in addition to nancial assets.

Imposing restrictions on the investors right to pledge or exchange their securities.

8] Turning back to calls: the rst decision that must be made is whether the call option is on the transferred assets or on the issued bonds. Either way, the SEC staff (EITF D-63) has said that the transfer must be accounted for as a secured borrowing. 9] There is some question as to whether the pledged assets in a securitization accounted for as a nancing should be classied as loans or as securities. Paragraph 10 of FASB 125 says: Upon completion of any transfer of nancial assets, [authors interpreta tion: whether or not it satises the conditions to be accounted for as a sale], the transferor shall: (a) continue to carry in its statement of nancial position any retained interest in the transferred assets, including, if applicable, servicing assets, benecial interests in assets transferred to a QSPE in a securitization, and retained undivided interests and (b) allocate the previous carrying amount between the assets sold, if any, and the retained interests, if any, based on their relative fair values at the date of transfer. The term transfer is dened in paragraph 243 to include putting it into a securitization trust or posting it as collateral. On the other hand, paragraph 12 goes on to say, If a transfer of nancial assets in exchange for cashdoes not meet the criteria for a salethe transferor and transferee shall account for the transfer as a secured borrowing with pledge of collateral.

If the pledged assets are treated as loans (their previous treatment), then they would likely be considered loans held for long-term investment and not loans held for sale. Thus there would be no FASB 65 LOCOM requirement, although valuation allowances for credit losses would be required.

If the pledged assets are treated as securities, then FASB 115 applies, and a decision as to held-to-maturity (HTM), trading, or available-for-sale (AFS) is required.

If classied as AFS, the asset side would be marked to market (affecting equity and comprehensive income), but there is no GAAP guidance concerning marking the corresponding liability side.

The

risk-based capital requirement for nancial institutions might be different if

the assets were classied as securities rather than loans.

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There

should be some other balance sheet caption to distinguish these pledged

assets from the loan or investment portfoliofor instance, Securitized assets subject to repurchase option. 10] In comparing pro forma projected results of weaning off of gain-on-sale accounting, dont forget the income from the accretion of yield (at the discount rate) on the residual interests retained in the sale accounting scenario. 11] The FASB has proposed extensive new disclosures relating to securitizations, including the number and volume of transactions, cash inows (outows) with the securitization trusts, disclosure of assumptions, and stress tests or sensitivity analyses of the value of the retained interests. These disclosures will not apply to securitizations accounted for as secured borrowings. Some companies provide supplemental information showing key nancial statement components on a pro forma basis as if their off-balance sheet securitizations were on-balance sheet. The FASB considered, but rejected, this type of presentation as being a required part of the new disclosures.

W H AT I F I C A N T R E AS O N A B LY E ST I M AT E FA I R VA L U E ?

In the event that it is not practicable to estimate the fair value of a retained asset, you must value it at zero. Valuing a retained interest at zero will often result in recognizing a loss on sale after considering transaction costs and any premium the transferor paid to acquire the assets or capitalized costs the transferor incurred to originate the asset. In the event that it is not practicable to estimate the fair value of any liability, you will not be able to recognize any gain on sale. You may be required to record a loss if a liability under FASB 5 and FASB Interpretation 14 (Reasonable Estimation of the Amount of a Loss) would be recognized. [45] When a securitizer concludes that it is not practicable to estimate fair values, FASB 125 requires footnote disclosure describing the related items and the reasons why it is not practicable to estimate their fair value. Practicable means that an estimate of fair value cannot be made without incurring excessive costs. It is a dynamic concept. What is practicable for one entity might not be for another; what is not practicable in one year might be in another. [211]

H OW I S G A I N O R LO S S D E T E R M I N E D I N A R E VO LV I N G ST R U C T U R E ?

Gain or loss recognition for receivables such as credit card balances, trade receivables or dealer oor plan loans sold to a revolving securitization trust is limited to receivables that

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exist and have been sold. Recognition of servicing assets is also limited to the servicing for the receivables that exist and have been sold. [52] FASB 125 requires an allocation of the

Questions related to determining gain or loss on sale

carrying amount of the receivables transferred to the SPE, between the sold interests and the retained interests (based on relative fair value) be performed. See credit card example on page 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 (we like to call them transferettes) are each treated as separate sales of new balances with the attendant gain or loss calculation. The record-keeping burden necessary to comply with these techniques is quite onerous, particularly for master trusts. Paragraph 46 of FASB 125 shows an example where the seller nds it impracticable to estimate the fair value of the servicing contract, although it is condent that servicing revenues will be more than adequate compensation for performing the servicing. The implicit forward contract to sell new receivables during a revolving period, which may become valuable or onerous 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. FASB 125 does not require securitizers to mark the forward to fair value in accounting periods following the securitization. Also forwards in revolving deals usually do not meet the denition of a derivative in FASB 133, Accounting for Derivatives, and thus are not covered by FASB 133s mark-to-market requirement.

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How about an example of a gain on sale worksheet or template?

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 + $ 99,000,000 purchase premiums + deferred origination costs deferred origination fees - purchase discount - loss reserves) Deal structure: PRINCIPAL AMOUNT PRICE FAIR VALUE * Class A Class B Class IO Class R *Including accrued interest
TOTAL Class IO and R are retained by the seller Servicing value: Up-front transaction costs (underwriting, legal,

$ 96,000,000 4,000,000

100 95

$ 96,000,000 3,800,000 1,500,000 1,000,000

$ 100,000,000

$ 102,300,000

700,000

accounting, rating agency, printing, etc.) Basis allocation of carrying value:

COMPONENT FAIR VALUE % OF TOTAL FAIR VALUE ($99MM X%) ALLOCATED CARRYING AMOUNT SOLD

$ 1,000,000

RETAINED

Servicing Class A Class B Class IO Class R

TOTAL

700,000 96,000,000 3,800,000 1,500,000 1,000,000

.68% 93.20 3.69 1.46 .97 100.00%

673,200 92,268,000 3,653,100 1,445,400 960,300

$ $ 92,268,000 3,653,100

673,200

1,445,400 960,300 $ 95,921,100 $ 98,800,000 $ 2,878,900 $ 3,078,900

$ 103,000,000

$ 99,000,000

Net proceeds (with accrued interest, after $1 million transaction costs) Pre-tax gain Journal entries:

DEBIT

CREDIT

(1) Cash Servicing asset Class IO Class R Net carrying value of loans Pre-tax gain on sale (2) Class IO Class R Other comprehensive income (earnings, if trading)

$ 98,800,000 673,200 1,445,400 960,300 $ 99,000,000 2,878,900 $ 54,600 39,700 $ 94,300

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In the second journal entry, the allocated carrying amounts of Class IO and Class R are adjusted upward to their fair values because they are required to be classied as either available for sale or trading securities. [39] Note the following: 1) a similar adjustment is not made for the servicing asset; and 2) a haircut on the amount of gain recognized applies when the Class IO and Class R are classied as available for sale and not trading.

Questions related to determining gain or loss on sale

How about a credit card 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 $ 650,000,000 Carrying amount, net of loss reserves $ 637,000,000 Servicing value $ 5,000,000 Value of xed-price forward contract for future sales 0 Up-front transaction costs $ 4,000,000 Losses are reimbursed from excess interest spread account Deal structure:
PRINCIPAL AMOUNT PRICE FAIR VALUE

Class A Class B Sellers certicate IO strip* Servicing

TOTAL

$ 500,000,000 25,000,000 125,000,000

100 100

$ 500,000,000 25,000,000 125,000,000 10,000,000 5,000,000 $ 665,000,000

$ 650,000,000

Basis allocation of carrying value:

COMPONENT FAIR VALUE % OF TOTAL FAIR VALUE ($637MM X%) ALLOCATED CARRYING AMOUNT SOLD RETAINED

Class A Class B Sellers certicate IO strip* Servicing

TOTAL

$ 500,000,000 25,000,000 125,000,000 10,000,000 5,000,000 $ 665,000,000

75.19% 3.76 18.80 1.50 .75 100.00

$ 478,960,300 23,951,200 119,756,000 9,555,000 4,777,500 $ 637,000,000

$ 478,960,300 23,951,200 $ 119,756,000 9,555,000 4,777,500 $ 502,911,500 $ 524,000,000 $21,088,500 $ 134,088,500

Proceeds net of $1 million allocated transaction costs (assumes 25% allocation to the initial sale) Pre-tax gain Journal entries:

DEBIT

CREDIT

(1) Cash IO strip Servicing asset Sellers certicate Deferred transaction costs Net carrying value of loans Pre-tax gain on sale (2) IO strip Equity (other comprehensive income)

$ 521,000,000 9,555,000 4,777,500 119,756,000** 3,000,000 $ 637,000,000 21,088,500 $ 445,000 $ 445,000

* In determining the fair value of the IO strip, the seller would consider the yield on the receivables, charge-off rates, average life of the transferred balances and the subordination of the IO ows in a spread account. ** Note that in the above example, the allocated carrying amount of the sellers certicate is less than its principal balance. FASB 125 does not provide any guidance on how such difference should be amortized. Presumably, it should be amortized as additional yield over the average life of the retained balances.

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 above would be made with a new gain or loss recorded. The record keeping burden to comply with these techniques is onerous, particularly for master trusts.
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I S FA I R VA L U E I N T H E E Y E S O F T H E B - H O L D E R ?

Neither FASB 125 or the exposure draft of the proposed amendment introduce any new accounting denition of fair value. The fair value of an asset or liability is dened as the amount at which it could be bought or sold (or settled), in a current transaction between willing parties, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, whenever available. [42] If quoted market prices are not available, the estimate of fair value should be based on the best information available. The estimate of fair value should consider prices for similar instruments and the results of valuation techniques, such as the present value of the estimated future cash ows using a discount rate commensurate with the risks involved, option-pricing models, Option-Adjusted Spread (OAS) and matrix pricing. [43] It would be unusual for a securitizer to nd quoted market prices for most nancial components arising in a securitization complicating the measurement process and requiring estimation techniques. FASB 125 discusses these situations as follows:
The

underlying assumptions about interest rates, default rates, prepayment rates

and volatility should reect what market participants would use.

Estimates of expected future cash ows 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 veried objectively.

If a range is estimated for either the amount or timing of possible cash ows, the likelihood of all possible outcomes should be considered in determining the best estimate of anticipated cash ows. [44]

In recent years, several public companies announced losses resulting from downward adjustments to previously recorded retained interests in securitizations. The adjustments often stemmed from securitized mortgage assets that prepaid more quickly than the sellers original estimates. The losses also led equity analysts to increasingly question the quality of earnings of many securitizers. The analysts pointed out that FASB 125 gains are, for the most part, non-cash; instead, the gains usually result from recording assets that represent an estimate of the present value of anticipated cash ows.

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In response, some securitizers indicated that they would utilize more conservative assumptions when calculating the gain on securitizations. More conservative assumptions mitigate or eliminate subsequent downward adjustments if adverse market developments occur. Also, in at least one well-publicized case, it was not clear that the securitizer would consistently apply assumptions. That is, it appeared that the securitizer might use more conservative assumptions for newly securitized assets but would not use similar assumptions

Questions related to determining gain or loss on sale

when estimating the fair value of retained interests in previously securitized assets. Different assumptions should be used only when warranted by the facts and circumstances of the specic assets securitized. For example, a securitizer is justied in making different estimates for loans with substantively different terms or economic characteristics. These developments prompted the SEC staff to make an announcement at the March 1998 EITF meeting, codied as Topic D-69 in the EITF Abstracts. Key points contained in the announcement are as follows: 1] Recognition of gains or losses on the sale of nancial assets is not elective. 2] In estimating the fair value of retained and new interests, the assumptions used in those valuations must be consistent with market conditions. Using assumptions that are not consistent with current market conditions in order to ascribe intentionally low or high values to new or retained interests is not appropriate. 3] Assumptions and methodologies used in estimating the fair value of similar instruments should be consistent. It would be inappropriate to use signicantly different values or assumptions for newly created retained interests that are similar to existing retained interests. 4] Signicant assumptions used in estimating the fair value of retained and new interests at the balance sheet date should be disclosed. Signicant assumptions generally include quantitative amounts or rates of default, prepayment and interest. The FASB proposed amendments to FASB 125 will require securitizers to provide disclosures well beyond the above list for transactions accounted for as sales, but not those accounted for as borrowings. See section 4 on page 45 for an illustration of the FASBs proposed disclosures. The Exposure Draft encourages early adoption of the disclosure requirements of a nal amended standard.

D O E S FAS B 1 2 5 G U I D E T H E S E PA R AT E F I N A N C I A L STAT E M E N T S O F T H E S P E ?

FASB 125 does not address the balance sheet accounting by the SPE, which is usually the registrant for SEC ling purposes, or related trusts. The various structures, though, may have implications for the form and content of audited nancial statements, which may be called for in 1934 Act filings. For pass-through certificate structures and for Collateralized Mortgage Obligations (CMOs) accounted for as sales, nancial statements have typically been considered not applicable.

C A N I R E C O R D A N AS S E T F O R S E RV I C I N G ?

Yes, if the benets of servicing are expected to be more than adequate compensation to service the assets. [13] 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 assigned to another servicer.
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Servicing is inherent to nancial assets; however, it only becomes a distinct asset when contractually separated from the underlying assets via a sale or securitization of the assets, with servicing retained. [35] A servicer of the assets commonly receives the benets of servicing revenues from contractually specied servicing fees, late charges and other ancillary revenues, including oat and incurs the costs of servicing those assets. Typically in securitizations, the benets of servicing are not expected to be less than adequate compensation to the servicer. Adequate compensation is the amount of benets of servicing that would fairly compensate a substitute servicer, should one be required, which includes the prot that would be demanded in the marketplace. Adequate compensation is determined by the marketplace; it does not vary according to the specic servicing costs of the servicer. Therefore, a servicing contract that entitles the servicer to receive benets 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. FASB 125 makes no distinction between normal servicing fees and excess servicing fees. The distinction made is between contractually specied servicing fees and rights to excess interest (IO strips). Contractually specied 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 benecial 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. 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 benecial owners of those assets. [243] Consider the following example: Financial assets with a coupon rate of 10 percent are securitized. The pass-through rate to holders of the SPEs benecial 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 following chart graphically depicts the arrangement.

ASSET

SECTION

75 50 25 0

ADEQUATE COMPENSATION

CONTRACTUAL SERVICING FEE

Basis Points 200 175 150 STRIP 125 100 SERVICING

IO

Questions related to determining gain or loss on sale

Servicing assets created in a securitization are initially measured at their allocated carrying amount, based upon relative fair values at the date of securitization. Rights to future interest income from the serviced assets in amounts that exceed the contractually specied 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 later. Servicing assets are to be amortized in proportion to, and over the period of, estimated net servicing income (the excess of servicing revenues over servicing costs). This is often referred to as the net income forecast or proportional method of amortization. If the estimated net servicing income in Month 1 represents 1 percent of the total (on an undiscounted basis) of the estimated net servicing income over the life of the pool, then 1 percent of the original asset recorded for servicing rights would be amortized as a reduction of servicing fee income in Month 1. This is in contrast to a depletion or liquidation method, which is based on declining principal balances or number of loans. The servicing asset must be subsequently evaluated and measured for impairment as follows: 1] Stratify servicing assets based on one or more of the predominant risk characteristics of the underlying nancial assets. Those characteristics may include nancial 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 shall be the amount by which the carrying amount of servicing assets for a stratum exceeds its 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 reect changes in the measurement of impairment subsequent to the initial measurement. Fair value in excess of the carrying amount for that stratum shall not be recognized. [37g] Servicing is not a nancial asset under FASB 125. 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. 90-21 and 95-5.

S H O U L D I R E C O R D A L I A B I L I TY F O R R E TA I N E D C R E D I T R I S K , O R I S I T PA RT O F T H E R E TA I N E D B E N E F I C I A L I N T E R E ST I N T H E AS S E T ?

The transferor should focus on the source of cash ows in the event of a claim by the trust. If the trust can only look to cash ows from the underlying nancial assets, the transferor has retained a portion of the credit risk through its retained interest, and a separate obligation should not be recorded. Possible credit losses from the underlying assets do affect, however, the measurement of the fair value of the transferors retained interest. In contrast, if the transferor could be obligated for more than the cash ows provided by its retained interest and, therefore, could be required to write a check to reimburse the trust or others for credit-related losses on the underlying assets, a separate liability should be recorded at fair value on the date of transfer.
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H OW A R E C AS H R E S E RV E AC C O U N T S H A N D L E D ? W H AT I S T H E C AS H - O U T M E T H O D ?

According to the FASB 125 Q&A Implementation Guide, Question 73, a cash reserve account is a retained interest in transferred assets. This is true regardless of whether the account is funded with the transferors own cash or cash is withheld from sale proceeds to establish the account. If the transferors own cash is used, then for purposes of the gain or loss calculation, the carrying amount of assets transferred is increased by the amount of cash deposited. If the cash deposit is funded with amounts withheld from sale proceeds, then for purposes of the gain or loss calculation, the amount of sale proceeds that is compared to the allocated carrying amount of the securities sold is reduced by the amount deposited. The net gain or loss recognized at the time of securitization will be affected by this sequence of events. Assuming the securitization is accounted for as a sale, the reserve account is recorded at its allocated basis, based on relative fair value on the transfer date. If the cash reserve account is inside the securitization trust and the sellers only entitlement to it is through its ownership of some form of residual certicate, then no separate asset is recorded for the account; rather, its fair value is included when estimating the fair value of the residual interest. The fair value of a cash reserve account will usually have to be estimated since there is no ready market for this type of asset. Consider the following example: Company A securitizes $100 million principal amount of loans, which produce excess interest of 100 basis points per annum after servicing fees and interest paid to investors. At the transfer date, $1 million in cash is deposited in an interest-bearing cash reserve account outside of the securitization trust. In subsequent periods, all cash distributions to which Company A as residual holder would otherwise be entitled are deposited in the cash reserve account and reinvested in eligible short-term investments. Any losses incurred on the pool are reimbursed to the Trust with funds transferred from the cash reserve account. When the reserve account balance accumulates to an amount in excess of 5% of the outstanding balance of the securitized assets, the excess is released to Company A. At subsequent dates, additional amounts based on lower percentages are scheduled to be released to the Company. Company A uses the cash-out method in its net present value calculation. Under this method, Company A projects the excess cash ows (increased by anticipated reinvestment income) as of the day they are available to the Company (the date(s) the amounts are released from the cash reserve account). This is in contrast to the cash-in method

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in which future cash ows are projected to occur earlier (and have a higher net present value); they are projected to occur as of the monthly dates the 100 bp of excess interest are generated on the loans (note that anticipated reinvestment income is excluded from that calculation). Separately, an amount of losses to be reimbursed to the Trust would be estimated.

Questions related to determining gain or loss on sale

According to question 75 in the FASB 125 Q&A Implementation Guide: The cash-out method estimates the fair value in a manner consistent with paragraph 43 [the fair value requirements of FASB 125] (that is, both the entire period of time during which the transferors use of the asset is restricted and the potential losses due to uncertainties are considered when estimating the fair value of the credit enhancement). The SEC staff goes even further. They have announced that the cash-in method could result in a material misstatement of the nancial statements, and several registrants have accordingly been required to le restated nancial statements.

H OW D O E S FAS B 1 2 5 T R E AT I O ST R I P S A N D OT H E R S E C U R I T I E S S U B J E C T TO P R E PAY MENT 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 classied as available for sale or trading under FASB 115. [14] This will apply regardless of whether these assets were purchased or were retained in a securitization. Note that some of these assets (e.g., uncerticated interest strips) were not previously subject to FASB 115 because they did not meet the denition of a security. No guidance is given as to the size of a premium that would trigger this provision. However, the FASB staff has said that 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 Planned Amortization Class (PAC) class vs. a support class. For most residual assets classied as available for sale, the write-down for the other than temporary impairment test specied in EITF 93-18 also applies. The 93-18 test calls for an income statement write-down to fair value, whenever the present value of the estimated future cash ows discounted at a risk-free rate is less than the amortized cost basis of the instrument. This impairment test must be performed on a deal-by-deal (asset by asset) basis. Unrealized appreciation in one asset cannot be used to offset impairment to be recognized on another asset. For those assets classied as trading, the impairment test of 93-18 would not apply, since the assets are already marked to market in earnings. Are there any special rules for mortgage bankers? (See page 39.)

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Comparison of contractual servicing asset vs. IO strip accounting under FASB 125
SERVICING ASSET IO STRIP

Denition

The value of amounts that, per the contract, are due to the servicer for servicing, if more than adequate compensation

Entitlements to interest spread beyond the specied servicing fee

Initial Recorded Amount Allocated cost-relative to fair market value Allocated cost-relative to FMV (FMV) Adjusted Initial Recorded Amount Income Recognition No adjustment Adjustment up or down to FMV through earnings, if trading, or equity (other comprehensive income), if available for sale Trading: Marked to market Available for sale: Level yield, prospective adjustment under EITF 89-4 Fair market value Trading: Marked to market Available for sale: Write-down to fair value under EITF 93-18 when yield is less than risk-free rate

Amortized in proportion to and over the estimated net servicing income Allocated cost, less accumulated amortization and valuation allowance Through valuation allowance for an individual stratum when carrying amount exceeds fair value; change in valuation allowance in earnings

Balance Sheet Carrying Value Recognition of Impairment

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 this potential earnings volatility, many issuers may look to ways to sell or repackage servicing and IO strips. Note that the transfer of servicing is covered in EITF Issues No. 90-21 and 95-5, not FASB 125. At the time of this writing, the EITF has added to its agenda, Issue No. 99-20, Recognition of Interest Income and Impairment on Certain Investments. Initially, the scope of the project will be limited to retained interests classied as either held-to-maturity or available-forsale. Existing GAAP does not provide robust guidance for the ongoing measurement of interest income and other adjustments for securitized debt instruments whose cash ows may change as a result of prepayments, credit losses, changes in an interest rate index and other reasons. Multiple interest income accounting models have been developed and applied for particular types of securities to deal with changes in their estimated future cash ows. These include the retrospective method, the prospective method and the catch-up

3
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method. Consider the following 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

Questions related to determining gain or loss on sale

to the senior classes. Because of this feature, the securitys fair value and allocated basis is signicantly less than its principal amount. At inception, a certain amount of prepayments and losses is expected. At the end of month one, (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. Question: How do you calculate interest income, including amortization of discount, in month 1? Stay tuned for further developments at the EITF .

A R E T H E R E A N Y S P E C I A L R U L E S F O R M O RT G AG E B A N K E R S ?

A mortgage banking enterprise was not originally given the same latitude as other securitizers with respect to the classication of retained interests in a securitization of its loans under FASB 125. A mortgage banker (i.e., an entity engaged in mortgage banking activities) was required to classify as trading (i.e., mark-to-market through earnings) all mortgagebacked securities retained after the securitization of mortgage loans held for sale. Retained mortgage-backed securities include senior and subordinated classes, IO strips and residuals. In FASB 134, at the urging of the Mortgage Bankers Association of America, the FASB decided to level the playing eld and to conform the classication choices of a mortgage banker to the classication choices of other securitizers pursuant to FASB 115. Now a mortgage banker can classify retained securities based on its ability and intent to sell or hold those investments, but is subject to the FASB 125 rule that IO strips and other premium securities subject to prepayment risk must be classied as either available-for-sale or trading. Also, in the event that a commitment to sell a tranche is made before or during the securitization process, that security must be classied as trading. Subordinated debt securities at a discount from face and Principal Only (PO) strips can be classied as held to maturity and accounted for at amortized cost if the entity has the ability and intent to hold those securities until maturity. One does not have to have the intent to sell a security in the near term to classify the security in the trading category. As pointed out in the gain on sale worksheet, the decision to classify a retained mortgage-backed security as trading vs. available for sale has immediate implications on the amount of income recognized in the period and possible future implications when testing for impairment on a security by security basis.

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W H AT I F W E P U T H U M P TY- D U M P TY B AC K TO G E T H E R AG A I N ?

A desecuritization is the process by which securities created in a securitization are transformed back into their underlying loans or other nancial assets. In EITF 90-2, a consensus had been reached that an investor should record an exchange of IO and PO securities of the same trust for the related mortgage-backed security at fair value at the date of the exchange with gain or loss recognized on the exchange. However, since FASB 125 does not allow sale treatment when an asset is exchanged for 100 percent of the benecial interests in that asset, it seemed logical to the FASB staff that sale treatment should not be allowed for the opposite case of an exchange of all of the benecial interests in the asset (e.g., senior and subordinated classes) for the asset itself (e.g., the mortgage loans). Accordingly, EITF 90-2 has been nullied. See EITF Topic D-51, The Applicability of FASB Statement No. 115 to Desecuritizations of Financial Assets.

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This booklet is written in general terms for widest possible use. It is intended as a guide only, and the application of its contents to specic situations will depend on the particular circumstances involved, as well as, the status of any future FASB interpretations or EITF issues. Accordingly, it is recommended that readers seek up-to-date information or professional advice regarding any particular problems that they encounter. This guide should not be relied on as a substitute for such advice.

STAY
TUNED

for
FURTHER DEVELOPMENTS

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W H AT S S L AT E D F O R 2 0 01 ?

The more signicant changes in the FASBs Exposure Draft (ED) of their proposed amendments to FASB 125 are summarized below. These amendments are slated to apply to transactions after December 31, 2000 and cannot be applied earlier.

1] The denition of a QSPE is revised

According to the ED, a QSPE must be a trust or legal vehicle that meets all of the following conditions:
BASIC GUIDANCE ADDITIONAL GUIDANCE

The QSPE has standing at law distinct from the transferor The QSPEs permitted activities are signicantly limited and are entirely specied in the legal documents that establish the SPE or create the benecial interests in the transferred assets that it holds It holds only: 1) Transferred nancial assets 2) Financial assets arising from derivative instruments (timing limitations apply) 3) Financial assets that assure third party servicing or timely pay of obligations due the QSPE 4) Servicing rights for assets the QSPE holds 5) Temporarily, non-nancial assets obtained in connection with collection of nancial assets the QSPE holds 6) Cash collected from nancial assets it holds and appropriate investments purchased pending distributions (limitations apply) If it can sell or distribute transferred assets to parties other than the transferor or its afliates, it can do so only in response to one of three conditions

If a transferor holds all of the benecial interests, it appears that the trust does not have standing at law distinct from the transferor. The permitted activities may be signicantly changed only with the approval of the holders of at least a majority of the benecial interests held by entities other than the transferor and its afliates. A temporary holding of foreclosed nonnancial collateral would usually comply with point 5. A QSPE cannot hold the unguaranteed residual value of a direct nancing or sales-type lease. A QSPE cannot hold nancial assets that would give the SPE signicant inuence over another entity (e.g. common stock in excess of 20%).

The conditions are: A decline in the fair value of transferred assets by a specied degree below their fair value at the date of transfer (triggered by a specied event or circumstance outside the control of the transferor or its afliates). Exercise by a Benecial Interest Holder (BIH) other than the transferor or its afliates of a right to put that holders benecial interest back to the SPE.

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Termination of the SPE or maturity of the benecial interests on a xed or determinable date that is specied at inception.

Determining Whether the Securitization Meets the Sale Criteria

2] Transferors, servicers and sponsors exclude the accounts of a QSPE from their nancial statements
Assets sold to a QSPE are not recognized as assets of a transferor, sponsor or servicer nor do these entities record as liabilities the related benecial interests issued by a QSPE. Why? The ED states that assets held in a QSPE are effectively the assets of its [benecial interest holders]. The guidance replaces EITF 96-20, although it effectively reaches the same conclusion. Note that the ED does not address consolidation accounting by investors (other than transferors, sponsors or servicers) in a QSPE. See footnote 9 on page 10.

3] The criteria for sale accounting are modied

FASB rejiggered the conditions for sale accounting (leaving alone the criterion for isolation). The following replaces paragraph 9b and 9c criteria (FASB 125 devotees know these paragraph numbers by heart): Transfers to QSPEs: 1) The holders of benecial interests have the right to pledge or exchange those interests and no condition both constrains them from taking advantage of that right and provides more than a trivial benet to the transferor. 2) The transferor does not retain effective control over transferred assets through the ability to unilaterally cause the transferee to return specic assets, other than through a cleanup call. Transfers to entities other than QSPEs: a) Each transferee obtains the right to pledge or exchange transferred assets, and no condition both constrains it from taking advantage of that right and provides more than a trivial benet to the transferor. b) The transferor does not maintain effective control over the transferred assets through an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity [e.g., most repurchase agreements].

4] Some securitizations that contain a Removal Of Accounts Provision (ROAP) cannot be accounted for as sales
Hotly debated since the issuance of FASB 125 are so-called removal of account provisions, usually found in revolving securitizations such as credit-card deals. The ED would nullify the guidance of EITF 90-18 and narrow the types of ROAPs that are compatible with sale accounting.

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Which ROAPs would preclude sale accounting? Those that result in the transferor retaining effective control over the transferred assets. It is critical that issuers review their outstanding agreements because the ED does not grandfather existing structures. Thus, if a deal involves an unacceptable removal of accounts provision, revolving transfers to the vehicle after December 31, 2000 would be accounted for as financings. Complicating the problem is the fact that ROAP revisions usually must be approved by existing holders of outstanding benecial interests. Consult the table for guidance:
ROAP PROVISIONS SALE ACCOUNTING IS PRECLUDED; THE ROAP GIVES TRANSFEROR EFFECTIVE CONTROL

Unconditional ROAP or repurchase agreement. The exercise of the ROAP is conditioned on a transferors decision to exit some portion of its business (e.g., canceling an afnity arrangement, spinning off a business segment, accepting a bid for a specied portion of the business). ROAP permits random removal of excess assets, if sufciently limited so that the transferor cannot remove specic assets. ROAP permits removal of defaulted receivables. ROAP is conditioned on a third party cancellation, or expiration without renewal, of an afnity or private-label arrangement.

Yes Yes

No No No

5] The reference to the powers of the FDIC is removed

The ED removes any reference to the FDIC (except in its Basis for Conclusions). Instead, the ED notes that the powers of receivers not subject to the U. S. Bankruptcy Code vary considerably, noting: For entities that are subject to other possible bankruptcy, conservatorship, or other receivership procedures in the United States or other jurisdictions, judgments about whether transferred assets have been isolated need to be made in relation to the powers of bankruptcy courts or trustees, conservators, or receivers in those jurisdictions. As a practical matter, we think that this proposed change will require that even entities insured by the FDIC will need an appropriate opinion from competent legal counsel that

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transferred assets have been isolatedunless the transfer is a straightforward sale (e.g., there is no continuing involvement) of nancial assets.

Determining Whether the Securitization Meets the Sale Criteria

T H E FAS B s P R O P O S E D N E W D I S C LO S U R E S

This appendix provides specic examples illustrating the disclosures that the FASB proposes be required by December 31, 2000, with earlier application encouraged. The FASBs format in the illustrations below is not required; the Board encourages entities to use a format that displays the information in the most understandable manner in the specic circumstances. Note X below illustrates the disclosure of accounting policies for retained interests. In particular, it provides a description for each major asset type of the accounting policies for (a) initially measuring and (b) subsequently measuring the retained interests, including the methodology for determining their fair value.

Note X Summary of Signicant Accounting Policies: Receivable Sales

When the Company sells receivables in securitizations of automobile loans and residential mortgage loans, it retains IO strips, one or more subordinated tranches, servicing rights, and in some cases a cash reserve account, all of which are retained interests in the securitized assets. Gain or loss on sale of the receivables depends in part on the previous carrying amount of the nancial assets involved in the transfer, which is allocated between the assets sold, if any, and the retained interests, if any, based on their relative fair value at the date of transfer. To obtain fair values, quoted market prices are used if available. However, quotes are generally not available for retained interests, so the Company generally estimates fair value based on the present value of expected future cash ows using managements best estimates of the key assumptionscredit losses, prepayment speeds, and discount rates commensurate with the risks involved. Note Y below illustrates disclosures about the characteristics of securitizations, the cash proceeds, and gain or loss from securitizations for each major asset type.

Note Y Sales of Receivables

During 19X2 and 19X1, the Company sold automobile loans and residential mortgage loans in several securitization transactions. In all those securitizations, the Company retained servicing responsibilities and subordinated interests. The Company receives (a) annual servicing fees approximating 0.5 percent for mortgage loans and 1.5 percent for automobile loans of the outstanding balance and (b) rights to future cash ows arising after the investors in the securitization trust receive the return for which they have contracted. The investors and the securitization trusts have no recourse to the Companys other assets for failure of debtors to pay when due. However, most of the Companys retained interests are generally restricted until investors have been paid or otherwise are subordinate to investors interests. The value of retained interests is subject to substantial credit, prepayment, and interest rate risks on the transferred nancial assets.

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In 19X2, cash proceeds from securitization of automobile loans and residential mortgage loans totaled $512.7 million and $400 million, resulting in pretax gains of $22.3 and $25.6 million respectively. In 19X1, cash proceeds from securitization of automobile loans and residential mortgage loans totaled $300.7 million and $250 million, resulting in pretax gains of $16.9 and $15 million respectively. Table 1 below presents quantitative information about key assumptions used in measuring retained interests at the time of securitization for each nancial period presented:

Table 1:
Key economic assumptions used in measuring the retained interest resulting from securitizations completed during the year were as follows:
19X2 Jumbo Mortgage Loans Fixed-Rate Adjustable2 10.00% 8.00% 19X1 Jumbo Mortgage Loans Fixed-Rate Adjustable2 8.00% 6.00%

Automobile Loans
(Key rates,1 all per annum)

Automobile Loans 1.00%

Prepayment Weightedaverage life (in years) 3 Expected credit losses Residual cash ows discounted at Projected coupons on oating rate tranches is based on the forward LIBOR curve plus the applicable spread
1 2

1.00%

1.8 3.10%

7.2 1.25%

6.5 1.30%

1.8 3.50%

8.5 1.25%

7.2 2.10%

12.00%

10.00%

12.50%

13.50%

11.75%

11.00%

Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics. Rates for these loans are adjusted based on an index (for most loans, the 1-year Treasury note rate plus 2.75 percent). Contract terms vary, but for most loans the rate is adjusted every 12 months by no more than 2 percent. 3 The weighted-average life of prepayable assets can be calculated by multiplying the principal collections expected in each future period by the number of months until that future period, summing those products, and dividing the sum by the initial principal balance.

Table 2 below combines disclosure of the key assumptions used in subsequently measur-

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ing the fair value of retained interests at the end of the latest period and the hypothetical effect on current fair value of two or more unfavorable variations from the expected levels for each key assumption. This illustration provides up-to-date information about the key assumptions used to measure the fair value of retained interests, highlights any change in the key economic assumptions from those used to record the retained interests at time of securitization, and describes the objectives, methodology, and limitations of the sensitivity analysis or stress test.

Determining Whether the Securitization Meets the Sale Criteria

Table 2:
At December 31, 19X2, key economic assumptions and the sensitivity of the current fair value of residual cash ows to immediate 10 percent and 20 percent unfavorable changes in assumptions are as follows:
(Amounts as of December 31, 19X2) (in millions) Carrying amount/fair value of retained interests 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 ows discount rate (annual) Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Interest rates on adjustable rate loans and tranches Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Automobile Loans Jumbo Mortgage Loans Fixed Rate Adjustable $12.0 6.5 11.5% $3.3 $7.8 .9% $1.1 $2.2 12.0% $.65 $.9 $13.3 6.1 9.3% $2.6 $6.0 1.8% $1.2 $3.0 11.0% $.5 $.9

$15.6 1.7 1.3% $.3 $.7 3.0% $4.2 $8.4 14.0% $1.0 $1.8

$1.5 $2.5

Based on forward yield curve plus applicable spread $.4 $1.5 $.7 $3.8

These sensitivities are hypothetical and should be used with caution. As the gures indicate, the change in fair value based on a 10 percent variation in assumptions cannot necessarily 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 independently from any change in another assumption; in reality, changes in one factor may contribute to changes in another, which might magnify or counteract the sensitivities. Table 3 below presents expected static pool credit losses.

Table 3:
Actual and Projected Credit Losses (%) as of: December 31, 19X2 December 31, 19X1 December 31, 19X0 19X0 5.0 5.1 4.5 Automobile Loans Securitized in 19X1 5.9 5.0

19X2 5.1

Note: Expected static pool losses are calculated by summing the actual and projected future credit losses and dividing the sum by the principal balance of the pool of assets at the time of securitization. The amount shown for each year is a weighted average for all securitizations during the year. Static credit losses are not disclosed for mortgage loans because estimated losses are relatively small and the estimates have changed very little over time.

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Table 4 below presents cash ows between the securitization SPE and the transferor.

Table 4:
Cash ows received from and paid to securitization trusts were as follows:
Year Ended December 31 19X2 19X1 $913 $551 212 112 226 254 (150) (25)

($000 omitted) Proceeds from securitization during the period Excess cash ow received on retained interests Servicing fees received Purchases of delinquent or foreclosed assets

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fasb
Test Your Knowledge

QUIZ

125

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T E ST YO U R K N OW L E D G E PA RT 1

Buy-It, Sign-It, Drive-It, Inc. (Buy-It) purchases retail installment auto contracts from a network of selected dealers in the Southwestern Region of the U.S. It has sustained its market share in the face of increasing competition by intensely focusing on its niche. Buy-It nances predominantly prime paperthe borrowers have solid credit histories and make a signicant down payment on the autos they purchase. Buy-It also leases autos to customers under its Why Pay? program. Buy-It acquires title to the cars and leases them to retail customers over 36 months, with a variety of customer choices concerning initial minimum payments, ongoing monthly rentals and buy-out provisions. Buy-It has sold some of its paper to Glorious Asset Trust, a multi-seller commercial paper conduit managed by a regional Bank. The balance of the portfolio is nanced on-balance sheet via a combination of the Companys equity and secured bank loans. Buy-It is considering its rst term auto loan securitization. The growing size of Buy-Its originations, the Companys good reputation in the market place, and the strength of its servicing operation all point to a successful securitization. You envision a classical two-step structure for the securitization. STEP 1

: Buy-It will form a wholly-owned bankruptcy remote special purpose entity,

Buy-It Financial Corp. (Financial). The loans will be transferred to Financial as an equity contribution.

STEP 2

: Financial will transfer the loans to a newly formed entity, Buy-It Owners Trust
(Trust), in exchange for (1) cash and (2) a certicate, representing the residual interest in the trust. Trust will nance the cash portion of the purchase price by issuing multiple tranches of debt. Financial will distribute to Buy-It the cash it receives from the Trust.

Other signicant terms of the transaction are as follows:

Buy-It will service the loans for a contractually specied servicing rate of 100 basis points.

Buy-It will have a call option on the sold loans when their principal is 10% or less of the original balance sold; a level at which the cost of continuing to service is considered burdensome.

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Buy-It sells all of the Class A and B tranches. As the residual holder, Buy-It is entitled to the net margin enjoyed by the Trust; i.e., the difference between the yield on the auto loans less the sum of the cost of the Trust debt, servicing, and ongoing administration.

Determining Whether the Securitization Meets the Sale Criteria

Cash ow to the Residual Certicate is subordinated all credit losses on the loans are allocated in their entirety to the Residual Certicate. In the unlikely event that credit losses exceed the Residuals ability to absorb defaults, losses will be allocated to the debt tranches in ascending order of priority.

All-in transaction costs will run $1,375,000.

R E Q U I R E D : W H AT S T H E B OTTO M L I N E ?

Determine the pre-tax gain or loss on the proposed sale in accordance with FASB 125, using information presented in the case and in the Fact Sheet below. We suggest that you create a worksheet like the template on page 30.

Fact Sheet
Loan Principal to be Securitized: $140 million Loss Allowance Recorded at the Sale Date: $100 thousand Expected Tranche Data: Class A-1 A-2 A-3 B Residual Principal $65,000,000 40,000,000 30,000,000 5,000,000 0 Rate Type Fixed Fixed Fixed Fixed Net Spread Rate 5.5% 6.0% 6.25% 6.55% Net Spread Sale Price 100% 100% 100% 95% N/A

Estimated Fair Value of Residual: Scenario Outcome Optimistic Fair Value Amount* $4,600,000 Major Assumptions: Historical trends continue except pool performance data improves in six months due to demonstrated effectiveness of new servicing system, increased training of personnel and improved policies and procedures. Historical trends continue. Higher discount rate used due to recent industry developments and estimated effect on liquidity of residual asset. Pessimistic $2,450,000 Same as best estimate except prepayments/losses increase due to softening of regional economy.

Best Estimate

$3,750,000

*These amounts represent a range of estimated fair values (i.e. willing buyer, willing seller) based on reasonable market based assumptions as to credit losses, prepayment rates and discount rates. Fair Value of Servicing Asset: $2.5 million Based on the amount a successor servicer would pay to assume the servicing rights and obligations

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Solution
The answer is $4,463,869.86. If you would like a copy of a worksheet showing the details of the calculation, you can e-mail jamjohnson@dttus.com or mrosenblatt@dttus.com.

T E ST YO U R K N OW L E D G E PA RT 2

The working group has assembled for an all-hands meeting. The objective of the meeting is to nail down some of the gritty issues of the securitization the following issues surface:
The

bankruptcy lawyers say: No doubt it should be a true sale at law. Theyre eval-

uating whether they can conclude that the transaction would be a true sale at law.
The

auditors ask if accrued interest at the sale date was factored into the gain

calculation.
The

rating agency wants more credit enhancement. Suggests company seed a $2.5

million reserve fund to be held by the trust, and allocate excess interest to the reserve fund until it grows to 3.75 percent of the outstanding balance. Amounts in the reserve fund would be invested in short-term, essentially risk-free, interest earning assets. Funds in excess of the required amount would be released to Buy-It from the reserve fund as a Residual Distribution.

Securitization team proposes alternative credit enhancement. Utilize Why Pay program. Transfer title to cars and assign related leases to Trust. Cash ow used only to absorb credit losses; otherwise reverts to Buy-It. Noted gagging reaction from lawyer and accountant.

The

CFO indicates initial calculation doesnt include amounts related to dealer

reserves. Buy-It advanced $2.5 million to dealers for their portion of nance charges related to certain loans in the pool. Under their arrangement with the dealers, the dealers will refund the premiums if the loans prepay/default any time during the rst 120 days that the loans are outstanding.

Required:
Be prepared to discuss the effects of each of these points on the accounting for the securitization. You need not quantify the effects.

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Determining Whether the Securitization Meets the Sale Criteria

Solution
Meeting Point Uncertainty Over Legal Opinion Effect on Accounting for the Securitization Critical for sale accounting. The companys outside accountants will need access to a legal opinion that concludes that the transaction would be a true sale at law. Buy-Its inability to obtain the appropriate opinion may result in the Company accounting for the transaction as an on-balance sheet collateralized borrowing. The carrying value of the loans is understated and the gain is overstated. To correct the calculation, Buy-It should include accrued interest in the carrying amount of the loan portfolio. Assuming that the waterfall already includes the receipt of all interest payments after the transfer date, there would be no effect on the fair value of the residual interest. Similarly, if the bonds are sold with pre-issue date accrued interest, that amount should be considered as additional sales proceeds Assets transferred would include the $2.5 million seed deposit and should be included in the basis allocation. The waterfall should be recalculated, including the effects of the additional cash in the trust on a cash-out basis and the residual certicate fair value amount increased by the result. Neither the autos under lease or the cash ows from an operating lease are nancial assets as dened by FASB 125. Thus, FASB 125 does not apply to their transfer (other accounting literature FASB 13 is on point). Inclusion of nonnancial assets in a securitization trust would usually result in Buy-It having to consolidate the accounts of the Trust, (it is not a QSPE nor does it have third party equity) thus defeating off-balance sheet sale treatment (see EITF 96-20). Also, inclusion of these assets might make it more difcult for the attorneys to conclude that a true sale has occurred. Dealer Reserves Dealer reserves should be understood carefully arrangements differ from entity to entity. In this case, the carrying amount of the loans was understated by the advance Buy-It made when it acquired the loans. However, Buy-It is also justied in recording an asset for the allocated fair value of the amount it expects to recover from the dealers, which would offset some of the reduction of the gain.

Accrued Interest on Sale

Reserve Fund

Using Operating Leased Assets as Credit Enhancement

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INDEX

125

Determining Whether the Securitization Meets the Sale Criteria

Index

Adequate compensation AICPA Auditing Interpretation on Lawyers Letters Auction sales Call reports Cash-out Method Cash Reserve Accounts Cleanup call Consolidation Convertible ARMs Credit card example Debt-for-tax Derivatives Desecuritization EITF Issue 93-18 EITF Issue 96-20 EITF Issue 99-20 Excess servicing Exposure Draft Fair value FASB 125 Q&A Implementation Guide FASB 133 on Derivatives FASB 134 for Mortgage Bankers FASIT FDIC 5/1 ARMs Float and ancillary fees Gain on sale worksheet Impairment Insurance companies Interest rate swap International securitization Lawyers letters Liquid asset Low-level recourse Money market tranche Mortgage bankers NAIC Non-nancial assets Put options

34 17 20 4 36 36, 52 7 12, 13, 26 , 10, 11, 12, 13, 14, 15 8 31 11, 12 9, 23, 29 40 37 10, 11 38 34 42 32 4 23, 29 39 4,22 16, 19, 44 8 34 30, 31 35, 37 4 9 4, 16 17 8 4 8 39 4 4, 9 7 12 ,

55

Qualifying special-purpose entity Regulatory accounting principles Removal of accounts provisions (ROAPs) Revolving structures Risk-based capital Rule 144A Servicing S.O.S. Speaking of Securitization Statutory accounting practices Topic D-14 of the EITF Abstracts Special-Purpose Entities Topic D-52 of the EITF Abstracts Codication Topic D-63 of the EITF Abstracts Call Options Topic D-66 of the EITF Abstracts Powers of an SPE Topic D-67 in the EITF Abstracts Powers of the FDIC Topic D-69 in the EITF Abstracts SEC Views on Assumptions Transferettes True sale at law Two-step transfer Uncerticated interest strips Warehouse arrangements

6, 8, 9, 10, 11, 12, 13, 14, 15, 19, 20, 42, 43 4 43 28, 29, 31, 43 4 7 4, 33, 34, 35, 38 1 4 11 4 7 12 , 19, 20 16 33 29, 31 6, 15, 16 6, 15, 16 37 13

This booklet is written in general terms for widest possible use. It is intended as a guide only, and the application of its contents to specic situations will depend on the particular circumstances involved, as well as, the status of any future FASB interpretations or EITF issues. Accordingly, it is recommended that readers seek up-to-date information or professional advice regarding any particular problems that they encounter. This guide should not be relied on as a substitute for such advice.

fasb
Securitization Accounting Under FASB 125

Y2K

EDITION
JANUARY 2000

125