Accounting Aspects of Asset SecuritizationSince the time of the first asset securitization transactions, the determination of whether the transfer of assets in a securitization should be accounted for as a sale or a secured borrowing has been challenging. FASB Statement No. 77, “Reporting by Transfer or for Transfers of Receivables with Recourse”, issued in 1983, and FASB Technical Bulletin No. 85-2, “Accounting for Collateralized Mortgage Obligations”, issued in 1985, led to confusion and inconsistency in accounting practices for financial asset transfers. FASB Technical Bulletin No. 85-2 provided that a sale of assets by an entity to an SPE that issued debt securities should be recorded as a borrowing if the seller obtained any of the securities issued by the SPE. However, in accordance with FAS 77, if an entity sold assets to an SPE that issued certificates/participations [equity type instruments as opposed to debt securities], the transaction was to be accounted for as a sale even if the originator obtained any of the securities or retained recourse.

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As a result of that confusion, FASB decided to adopt a financial components approach that focuses on control and recognizes that financial assets and liabilities can be divided into a variety of components. In June 1996, the FASB issued FASB Statement No. 125, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” [FAS 125], which provided accounting and reporting standards for sales, securitizations, and servicing of receivables and other financial assets, secured borrowing and collateral transactions, and the extinguishments of liabilities.

FAS 125 applied to transactions occurring after December 31, 1996. Almost immediately after the FASB issued FAS 125, constituents began asking for  reconsideration and clarification of certain of its provisions, even beyond the guidance provided in the FAS 125 Implementation Guide. In response to the growing need for reconsideration and clarification, the FASB agreed that amendments to FAS 125 were necessary and decided that a replacement would be more user friendly than simply amending the FAS 125 guidance. As a result, FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” [FAS 140] was issued in September 2000. FAS 140 retained the concepts of FAS 125 but the ground rules for determining whether a transfer of financial assets constitutes a sale or secured borrowing were clarified.

 

U.S. Accounting Overview

FAS 140 is based on a financial-components approach that focuses on control of the financial components of the assets. Under this approach, the accounting for a financial asset is determined for each of the components that are contractually created and accounted for based on the interests transferred and interests retained. Following a transfer of financial assets, an entity recognizes the assets it controls and liabilities it has incurred, and derecognizes financial assets for which control has been surrendered and all liabilities that have been extinguished. For example: if an entity transfers a loan receivable in a transaction in which a third party has acquired control over the future principal payments but the seller retains control over future interest payments, FAS 140 would consider the entity to have sold the “principal” component of the loan and to have retained the “interest” component.

If the seller in this example also has guaranteed the third-party investor that the debtor will make all contractually required principal payments, the seller would recognize a liability for the financial guarantee contract it has provided the investor. Under this model, components of the transferred asset, or newly created instruments require separate accounting recognition. For example, an interest rate swap might exist in a transfer of financial assets that qualifies as a sale even though no formal interest rate swap agreement exists. This can occur in situations in which financial assets are securitized and the rate paid to investors is determined on a basis different than the rate paid by the debtor. For example, a swap is deemed to exist where a fixed rate receivable is sold to an investor that receives all payments made by the debtor except that the interest payments are converted to a variable rate of interest. In this situation, the economic components of the transfer result in the creation of an interest rate swap.

The components of a financial asset are determined based on the contractual components that are created as a result of the transfer. For example: consider a transfer of a portfolio of fixed rate receivables in which the buyer is to receive the first 90% of all principal collections, a variable rate of interest, and receives a guarantee of principal and interest collections. In this case, the transferor would be viewed as retaining a single retained interest that represents a combined principal-only strip, interest rate swap, and financial guarantee contract. It would not separately account for the three financial components retained. However, each of the three components that are combined into the retained interest will impact the cash flow that will result from the retained interest and, therefore, its fair value.

The importance of carefully understanding each aspect of a transfer involving financial instruments cannot be overemphasized.

 

Under FAS 140, a transferor/originator is considered to have surrendered control over transferred assets and, therefore, to have sold the assets [to the extent that consideration other than beneficial interests in the transferred assets is received in exchange], only if all of the following conditions are met:

  • Legal isolation. The transferred assets have been isolated from the transferor/originator—put presumptively beyond the reach of the transferor/originator and its creditors, even in bankruptcy or other receivership.
  • Right to pledge or exchange. Each transferee [or, if the transferee is a QSPE [see 21.5], each holder of its beneficial interests] has the right to pledge or exchange the assets [or beneficial interests] it received, and no condition both constrains the transferee [or holder] from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor/originator.
  • Effective control criteria. The transferor/originator does not maintain effective control over the transferred assets through either an agreement that both entitles and obligates the transferor/originator to repurchase or redeem them before their maturity or the ability to unilaterally cause the holder to return specific assets, other than through a clean-up call.

 

Transfers of financial assets in which the transferor/originator has no continuing involvement with the transferred assets or with the transferee have not been controversial. However, transfers of financial assets often occur whereby the transferor/originator has some form of continuing involvement either with the assets that have been transferred or with the transferee. Typical examples of continuing involvement include recourse provisions relating to the assets transferred, servicing arrangements, and agreements or options to repurchase or reacquire the transferred assets. Transfers of financial assets with continuing involvement raise questions about whether the transfers should be accounted for as sales or as secured borrowings.

The three criteria above establish the standard for determining when the transfer of financial assets should be considered a sale or as a secured borrowing. We are going to talk about sale criteria in more detail on the next section. Read on….

 

Sale Criteria

Legal Isolation

The facts and circumstances surrounding the transfer of assets must provide reasonable assurance that the transferred assets would be beyond the reach of the transferor/originator, or the powers of a bankruptcy trustee or other receiver [e.g., the Federal Deposit Insurance Corporation for FDIC insured entities or the SPCE for broker-dealers] for the transferor/originator or any of its affiliates.

Derecognition of transferred assets is appropriate only after all available evidence that either supports or questions the isolation assertion has been considered and found to provide reasonable assurance that the transferred assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor/originator or any of its consolidated affiliates. However, if the transferor/originator has continuing involvement with the transferred assets, the assistance of legal counsel likely will be required. Typically, a “true sale/nonconsolidation” opinion is obtained from a bankruptcy attorney. Statement of Auditing Standards No. 73, “Use of Specialist’s Opinion Required in Most Securitization Transactions,” provides guidance on reviewing the legal opinion and indicates that a “would be” true sale level of assurance is required. The “would be” opinion is the highest level of assurance an attorney can give. In addition, the opinion should indicate that the SPE would not be consolidated with the transferor by a bankruptcy court.

 

Right to Pledge or Exchange

In assessing whether this criteria for sales treatment under FAS 140 has been met, the first question that should be addressed is whether the transferee [or the beneficial interest holders of a QSPE] is constrained from pledging or exchanging its purchased assets [or the beneficial interests] in such a way as to keep it from obtaining all or most of the cash inflows associated with its ownership.

In implementing FAS 125, issues arose concerning the types of constraints on the transferee’s right to pledge or exchange transferred assets which preclude sale accounting and whether a transferee must obtain either the right to pledge transferred assets or the right to exchange them or whether a transferee must obtain both rights for the transfer to qualify for sale accounting. This issue was resolved in FAS 140 as the emphasis is on providing the transferee with the ability to obtain all or most of the cash flows, not on the method of doing so [i.e., whether it can either exchange or pledge].

The second question that should be addressed if one concludes that the transferee or the holder of a QSPE’s beneficial interest is constrained is whether or not the constraint provides more than a trivial benefit to the transferor/originator.

 

The following is a list of examples of provisions that would typically be considered constraining:

  • A prohibition on the transferee’s subsequent sale of its interests
  • A prohibition on the sale to a competitor, if that competitor would be the only willing buyer for the type of asset concerned
  • A right for the transferor/originator to buy back the transferred assets that are “deep in the money” at the time of transfer

 

Some conditions do not constrain a transferee [or beneficial interest holders] from pledging or exchanging the assets [or beneficial interests] and therefore do not preclude a transfer subject to such a condition from being accounted for as a sale. For example: a transferor/originator’s right of first refusal on the occurrence of a bonafide offer to the transferee or beneficial interest holder from a third party presumptively would not constrain a transferee, because that right in itself does not enable the transferor/originator to compel the transferee to sell the assets and the transferee would be in a position to receive the sum offered by exchanging the asset, albeit possibly from the transferor/originator rather than the third party.

However, a transferor’s right of first refusal when the transferor holds the residual interest in the transferred assets is a constraint that provides more than a trivial benefit to the transferor and would preclude sale treatment.

 

Further examples of conditions that presumptively would not constrain a transferee [or beneficial interest holder] include:

  • A requirement to obtain the transferor/originator’s permission to sell or pledge that is not to be unreasonably withheld
  • A prohibition on sale to the transferor/originator’s competitor if other potential willing buyers exist
  • A regulatory limitation such as on the number or nature of eligible transferees [as in the case of securities issued under Securities Act Rule 144A or debt placed privately]
  • Illiquidity, for example, the absence of an active market These provisions should be considered in connection with the other provisions and restrictions in the transaction or rights retained by the transferor/originator, as they may not constrain the transferee [or beneficial interest holder] individually, but may as they work in combination with other aspects of a transaction.

 

Whether a constraint is of more than a trivial benefit to the transferor is not always clear, but as transferors presumably incur costs if they impose constraints, since transferees pay less than they would pay to obtain the asset without constraint, imposition of a constraint by a transferor typically results in more than a trivial benefit to the transferor. For example: a provision in the transfer contract that prohibits selling or pledging a transferred loan receivable not only constrains the transferee but also provides the transferor with the more-than-trivial benefits of knowing who has the asset, a prerequisite to repurchasing the asset, and of being able to block the asset from finding its way into the hands of a competitor for the loan customer’s business or someone that the loan customer might consider an undesirable creditor.

Transferor-imposed contractual constraints that narrowly limit timing or terms, for example, allowing a transferee to pledge only on the day assets are obtained or only on terms agreed with the transferor, also constrain the transferee and presumptively provide the transferor with more-than-trivial benefits.

 

Additionally, a condition not imposed by the transferor that constrains the transferee may or may not provide more than a trivial benefit to the transferor. For example, if the transferor refrains from imposing its usual contractual constraints on a specific transfer because it knows an equivalent constraint is already imposed on the transferee by a third party, it presumptively benefits more than trivially if it is aware at the time of the transfer that the transferee is constrained. However, the transferor cannot benefit from a constraint if it is unaware at the time of the transfer that the transferee is constrained.

 

Effective Control Criteria

Under FAS 140, if the transferor/originator has any ability to unilaterally reclaim specific transferred assets on terms that are potentially advantageous to the transferor/originator—whether through a removal-of-accounts provision, the ability to cause the liquidation of the special purpose entity, a call option, forward purchase contract, or other means—sale treatment is precluded because, in those circumstances, the transferor/originator would still effectively control the transferred assets. The transferor/originator maintains effective control by being able to initiate action to reclaim specific assets with the knowledge that the transferee cannot sell or distribute the assets because of restrictions placed on it.

A right to reclaim specific transferred assets by paying fair value for the assets when reclaimed generally does not maintain effective control, because it does not convey a more than trivial benefit to the transferor/originator. However, a transferor/originator has maintained effective control if it has such a fair value right and also holds the residual interest in the transferred assets because it can unilaterally cause their return. For example: if a transferor/originator can reclaim such assets by purchasing them in an auction at the termination of the transaction/QSPE, and thus at what might appear to be fair value, then sale accounting for the assets it can reclaim would be precluded. Such circumstances provide the transferor/originator with a more than trivial benefit and effective control over the assets, because it can pay any price it chooses in the auction and recover any excess paid over fair value through its residual interest.

Some rights to reacquire transferred assets [or to acquire beneficial interests in transferred assets held by a QSPE], although they do not constrain the transferee, may result in the transferor maintaining effective control over the transferred assets through the unilateral ability to cause the return of specific transferred assets. Such rights preclude sale accounting. For example: an investor in a beneficial interest with an attached call would not be constrained because, by exchanging or pledging the asset subject to that call, it would be able to obtain substantially all of its economic benefits. However, an attached call could preclude sale accounting as it may result in the transferor maintaining effective control over the transferred asset[s] because the attached call gives the transferor the ability to unilaterally cause whoever holds that specific asset to return it.

In contrast, transfers of financial assets subject to calls embedded by the issuers of the financial instruments, for example: callable bonds or prepayable mortgage loans, do not preclude sale accounting. Such an embedded call does not result in the transferor maintaining effective control, because it is the issuer rather than the transferor who holds the call.

If the transferee is a QSPE, it is constrained from choosing to exchange or pledge the transferred assets. As such, any call held by the transferor is effectively attached to the assets and could—depending on the price and other terms of the call—maintain the transferor’s effective control over transferred assets through the ability to unilaterally cause the transferee to return specific assets. For example: a transferor’s unilateral ability to cause a QSPE to return to the transferor or otherwise dispose of specific transferred assets at will or, for example, in response to its decision to exit a market or a particular activity, could provide the transferor with effective control over the transferred assets. As a result, the transfer of receivables with a right to reacquire those associated with a specific division or operating unit will not generally be treated as a sale.

The effective control criteria also precludes sale accounting for transfers of financial assets subject to an unconditional removal-of-accounts provisions [ROAP] that allows the transferor to specify the assets removed. The most common example of a ROAP is the right to specify accounts to be removed from credit card master trusts. The effective control criteria also precludes sale accounting for transfers of financial assets subject to a ROAP in response to a transferor’s decision to exit some portion of its business. The FASB reached this conclusion because such provisions allow the transferor to unilaterally remove specified assets from the QSPE, which demonstrates that the transferor retains effective control over the assets.

Certain other types of ROAPs that are commonly found in securitization structures are permissible. For example: a ROAP is permitted if it allows the transferor to remove specific financial assets after a third-party cancellation, or expiration without renewal, of an affinity or private-label arrangement on the grounds that the removal would be allowed only after a third party’s action [cancellation] or decision not to act [expiration] and if it could not be initiated unilaterally by the transferor. Also, a ROAP is permitted that allows the transferor to randomly remove transferred assets at its discretion, but only if the ROAP is sufficiently limited [i.e., to excess assets] so that it does not allow the transferor to remove specific transferred assets, for example, by limiting removals to the amount of the transferor’s retained interest and to one removal per month.

A clean-up call, however, is permitted as an exception to the effective control criteria. A clean-up call is an option held by the servicer or its affiliate, which may be the transferor, to purchase the remaining transferred financial assets, or the remaining beneficial interests not held by the transferor, its affiliates, or its agents in a QSPE [or in a series of beneficial interests in transferred assets within a QSPE], if the amount of outstanding assets or beneficial interests falls to a level at which the cost of servicing those assets or beneficial interests becomes burdensome in relation to the benefits of servicing.

 

Consolidation On Asset Securitization

Once it is concluded that the transfer meets the three sale criteria discussed above, the transferor/originator must determine whether the SPE that holds the assets and issues the beneficial interests must be consolidated. If a transfer is accounted for as a sale and the SPE is subsequently consolidated in the transferor’s consolidated balance sheet, then the result would be that the transferor continues to recognize the transferred assets.

The first and most typical way for the transferor/originator in a securitization to avoid consolidating the SPE, is to structure the SPE as a qualifying SPE [QSPE]. FAS 140 provides that a QSPE should not be consolidated in the financial statements of a transferor or its affiliates. This does not exempt beneficial interest holders other than the transferor from consolidating the SPE should they be deemed to have control.

Any entity that is not a transferor of financial assets to a QSPE, including a transferor that transfers financial assets to an SPE that does not meet the qualification criteria, should consider other guidance on consolidation policy [FAS 94, EITF Topic D-14, EITF 90-15, and related guidance].

 

Decision Tree Of Asset Securitization

Here is an example of a decision tree:

Decision Tree Asset Securitization

 

 

Initial Accounting/Gain-on-Sale Calculation

Upon completion of a transaction that satisfies the conditions to be treated as a sale and avoids consolidation, the gain or loss from such sale needs to be determined in accordance with FAS 140. The gain or loss will be recognized on the portion of the assets sold and the interests retained will be recorded at an allocated book value. FAS 140 requires that on completion of a sale of financial assets, the previous carrying amount is to be allocated between the assets sold and any retained interests based on their relative fair values at the date of transfer. Retained interests in transferred assets consist of portions of the assets that existed prior to the transfer that the transferor continues to hold subsequent to the transfer. The most common examples include a servicing contract with respect to the transferred assets, or a portion of the principal balance or interest collections from the transferred assets.

Recognition of gains or losses on the sale of financial assets is not elective and the transferor may not defer in the balance sheet a gain or loss resulting from the sale of financial assets.

 

Example:

The following example illustrates the gain-on-sale calculation for a transfer that meets the sale criteria.

Example: Assume a financial institution sells a portfolio of loans with a principal amount and net carrying amount of $1,000 to an SPE for $900 cash and a residual interest. The financial institution will also continue to service the loans for a contractual servicing fee of 2% of the outstanding balance annually. The principal and interest collections will be used to pay the investors first. Any remaining cash flow after losses, prepayments, and expenses will be paid to the residual holder.

The first step is to determine the components the interests sold and the interests retained. In this example, the financial institution retained the residual interest and the servicing. The next step is to calculate the fair value of each component. The proceeds received, the $900 of cash, represents the fair value of the interest sold. The fair value of the residual interest is determined through a discounted cash flow analysis. The cash flows to the residual holder are estimated based on the contractual cash flows of the assets, assumptions such as losse and prepayments, and the cash flow waterfall with the transaction. The discount rate used to present value the estimated cash flows is commensurate within the risk of the residual interest. The fair value of the residual interest is $188.52 in this example.

Under FAS 140, an entity that contracts to service financial assets that it does not own generally will be required to recognize either a servicing asset or a servicing liability. A servicer of financial assets commonly receives the benefits of servicing—revenues from contractually specified servicing fees, late charges, and other ancillary income, including “float”—as compensation for performing the servicing activities and incurring the related costs of servicing the assets. When the benefits of servicing are more than adequate compensation for a servicer performing such servicing, the contract results in a servicing asset. Adequate compensation is defined as the amount of benefits of servicing that would fairly compensate a substitute servicer should one be required, that includes the profit that would be demanded in the marketplace.

A servicing contract with adequate compensation would be able to be transferred to a substitute servicer without a corresponding payment or receipt. If the benefits of servicing are not expected to adequately compensate a servicer for performing the servicing, the contract results in a servicing liability. In the case of a transfer of assets accounted for as a sale, a servicing liability would serve to reduce the net proceeds of the sale, thus decreasing the gain on the sale or increasing the loss. A servicing asset would be treated as a retained interest in the securitized asset and, therefore, initially would be carried at an amount based on its allocated book value. FAS 140 clarifies that servicing assets and liabilities are not to be netted for financial reporting purposes. Rather, they are to be treated separately as assets and liabilities. Since the 2% contractual servicing fee in this example is more than adequate compensation, a $25 fair value resulted.

FAS 140 also requires that a transferor recognize any newly created assets obtained and liabilities incurred in a transaction. These items usually would include put or call options held or written, guarantee or recourse obligations, forward commitments to deliver additional receivables [e.g., in connection with reinvestment provisions of some credit card securitizations], swaps [e.g., provisions that convert interest rates earned by the transferee from the fixed rate paid by the debtor to a variable rate], and servicing liabilities, if applicable. These items would be initially measured at fair value. Expenses such as accounting, legal and underwriting fees reduce the gain.

 

Subsequent Accounting and Asset Securitization

FAS 140, with certain notable exceptions concerning servicing assets and liabilities and financial assets subject to prepayment as discussed below, does not provide guidance about the subsequent accounting for items that are recorded as a result of applying its provisions. Accordingly, assets and liabilities recorded as a result of applying FAS 140 will be treated in accordance with existing generally accepted accounting principles [GAAP] applicable to the item. Some of the items emanating from transfers of financial assets may be debt securities that are addressed by FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities” [FAS 115] or derivative financial instruments that are addressed by FAS 133, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” [FAS 133].

FAS 140 provides that interest-only strips, loans, other receivables, retained interests in securitizations, or other financial assets that can contractually be prepaid or settled in such a way that the holder would not recover substantially all of its recorded investment [except for instruments that are within the scope of FAS 133] shall be recognized like an investment in debt securities classified as available-forsale or trading under Statement 115. Accordingly, changes in the value of these instruments will be included in equity [other comprehensive income] until realized when they are considered available-for-sale. However, if the instruments are designated as trading, changes in fair value will be included in income immediately. Financial assets subject to prepayment risk may not be classified as held-to-maturity securities.

In late 2000, EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets“, was issued which discusses how a transferor/originator that retains an interest in securitized financial assets or an enterprise that purchases a beneficial interest in securitized financial assets, should account for interest income and impairments while the assets are held.

EITF 99-20 adopts the prospective method for recognizing interest income. Under EITF 99-20, the holder of a beneficial interest should recognize the excess of all future cash flows estimated at the initial transaction date over the initial carrying amount as interest income over the life of the beneficial interest using the effective yield method. The holder of a beneficial interest should continue to periodically [e.g., quarterly] update the estimate of future cash flows attributable to the beneficial interest.

If such evaluation results in a change [favorable or adverse taking into account both the timing and amount] in cash flows from the cash flows previously projected, then the amount of accretable yield should be recalculated and recognized prospectively as a change in the amount of periodic accretion recognized over the remaining life of the beneficial interest.

The interest must also be assessed for impairment each period. If there is an adverse change in the estimated future cash flows and the fair value is lower than the carrying amount, an impairment has occurred. The asset should be written down with the amount reflected in the income statement.

In the example above, the residual interest would be accounted for like a debt instrument classified under FAS 115 and the income and impairments would be accounted for in accordance with EITF 99-20. FAS 140 requires that a servicing asset or liability be amortized to income or expense in proportion to and over the period of estimated net servicing income or net servicing loss. However, if the fair value of a servicing liability subsequently increases above the carrying amount [e.g., because of significant changes in the amount or timing of actual or expected future cash flows from the cash flows previously projected], the servicer should revise its earlier estimates and recognize the increased obligation as a loss in earnings. A servicing asset or liability should be assessed for impairment.