Yesterday (April 2, 2008), FASB voted to remove the Qualified Special Purpose Entity (QSPE) concept (used for some securitizations) from FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and to remove the related scope exception from FIN 46R, Consolidation of Variable Interest Entities (VIEs). In addition to removing the QSPE concept, the board also approved amendments to the derecognition criteria in paragraph 9 of FAS 140 (changes shown in redline form on pages 1-2 of the board handout), and agreed to provide guidance on the ‘unit of account’ as relates to when a ‘portion’ of an asset can be derecognized - by requiring essentially the same characteristics as proposed in FASB’s 2005 Exposure Draft of proposed amendments to FAS 140 with respect to the definition of ‘participating interest,’ (definition appears on pages 3-4 of the board handout). FASB's project page currently states an amended Exposure Draft (ED) is expected to be released in the second quarter of 2008; in my estimation, the proposed changes decided yesterday are likely to be included in that ED or in a separate proposal document.
The QSPE concept specified in FAS 140 had been criticized, particularly in light of recent market turmoil tied largely to origination (and related issues involving securitization) of subprime mortgages. To obtain ‘sale treatment’ or off-balance sheet treatment for assets transferred or sold to a QSPE, (and for asset transfers generally) the transferor (e.g. a bank or other originator of mortgages) must give up control over the assets, otherwise the assets would have to remain on the transferors balance sheet (and gain on sale would be limited). The QSPE concept as defined in FAS 140 provided a means to demonstrate control was given up by the transferor, however, the restrictions specified in FAS 140 prohibiting a QSPE from managing the underlying assets, unless pre-specified in the original documents of the securitization trust, or agreed to subsequently by a majority of the investors in the trust, was viewed by some as threatening the ability of lenders and servicers to modify the terms of mortgages to help borrowers avoid foreclosure in the recent credit crunch.
Expedited Action In Light Of Credit Crunch Responds To SEC, PWG Request
FASB has had a longer term project to amend FAS 140, dating back to its 2005 Exposure Draft. The expedited nature of dealing with the QSPE issue as a short-term project was in response to a request from the SEC that FASB address this issue by year-end (noted on page 4 of this letter to the AICPA and FEI), and in response to a recommendation of the President’s Working Group (PWG) - in its March 13 report - calling on ‘authorities’ to encourage FASB to ‘evaluate the role of accounting standards in the current market turmoil… includ[ing] an assessment of the need for further modifications to accounting standards related to consolidation and securitization.’
FASB Project Manager Pat Donoghue told the FASB board that requests had come from ‘preparers and others’ to deal with the QSPE issue expeditiously. She explained, “We have significant issues in practice; constituents cannot consistently apply the guidance to products we have today.”
FASB board member Don Young asked if the objective of the short-term project on QSPEs was solely to provide preparer relief, or if it would improve financial reporting for investors. FASB staff responded there are two objectives to the project, one is short-term to respond to issues in practice that have been exacerbated by the current market turmoil and developments in securitization since FAS 140 was written, but the longer-term objective of broader amendments to improve FAS 140 remained.
FASB staff also recommended that their long-term project to amend FAS 140 be tackled as a joint project with the IASB, and could include a broad look at derecognition (e.g, off-balance sheet or ‘sale’ treatment of securitizations and asset transfers.) Among the issues FASB previously deliberated at board meetings last year was whether to move to a ‘linked presentation’ model, aimed at providing more transparency to investors by linking assets transferred with a related liability, so investors could determine for themselves the implications of net vs. gross treatment, vs. the current model allowing off-balance sheet treatment.
In voting to support the FASB staff’s proposal to remove the QSPE concept from the accounting literature, a number of board members mentioned there were longstanding difficulties with the QSPE concept that were exacerbated in the credit crunch relating in particular to subprime mortgage securitizations.
“For five years now we’ve struggled with application of [FAS] 140 [and] the fundamental question related to servicer discretion,” said board member Larry Smith. “We said, it’s almost impossible to structure a vehicle with the objectives the board had in mind when they created QSPEs: that is, an entity that has no decision making whatsoever relative to the run-out of these assets.”
He added, “I think the staff is appropriate in recommending that we do away with QSPE’s; there are no assets short of US treasury assets that somebody doesn’t make decisions over during the life of [those] assets.”
“We have a concept that really isn’t working, and we need to come up with some other way to help investors evaluate what these transactions are,” said Smith. “At the end of the day, I don’t think the current application of 140 is what the board that approved 140 had in mind, therefore I think we should just stop pretending, and eliminate QSPE’s from our literature, and rely on other aspects of the consolidation model to give [us an] answer that is appropriate.”
Recap of Accounting Developments Relating to Subprime Securitizations
Last summer we started covering developments in the subprime crisis, particularly as relate to accounting issues, including governmental requests for clarification of the accounting rules for securitization as they may impact lenders, servicers, investors and others abilities and desire to modify the terms of mortgages that are at risk of going into default. See, e.g. “Those Curious QSPEs,” “FASB … To ‘Get Out of the Way’ on Debate Over Subprime Accounting,” “Schumer Asks Big Four to Share SEC Guidance on Loan Modifications,” and “Policy Paper of Multi-State Task Force of Ten State Attorneys General Calls for Modification of Subprime Mortgages.”
Among the items noted was a letter from SEC Chairman Christopher Cox to House Financial Services Chairman Barney Frank on July 24, 2007. Although the letter concluded that loan modifications when default is reasonably foreseeable “would not result in a requirement for entities to account for those securitized assets on their balance sheets,” the letter also included a detailed attachment from the Chief Accountant to the SEC Chairman, which included a discussion about permissible activities of QSPEs as set forth in FAS 140, which said, “Many mortgage loans are securitized using QSPE structures. The FASB intended for QSPEs to be entities that would not be actively managed and instead would be on ‘auto pilot.’”
As we noted in this blog last year, in trying to interpret the guidance on QSPEs set forth in FAS 140 and expressly described in the detailed attachment to SEC’s July 24, 2007 questions were raised in some minds as to whether the general guidance in the cover letter from SEC Chairman Cox to Rep. Frank was ‘unequivocal,’ as it had been so described in an August 23, 2007 letter from Sen. Charles Schumer to the CEOs of the ‘Big Four’ audit firms, as cited in this Alert published August 24, 2007 by the Center for Audit Quality (CAQ).
Further guidance appeared in an SEC letter dated Jan. 8, 2008 addressed to the AICPA and FEI, in which the SEC Chief Accountant said, “The Office of the Chief Accountant(“OCA") has been asked by preparers, auditors, ASF [American Securitization Forum], the U.S. Department of the Treasury, and others whether modifications of Segment 2 subprime ARM loans that occur pursuant to the ASF Framework would result in a change in the status of a transferee as a qualifying special-purpose-entity ("QSPE") under paragraph 55 of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities ("Statement 140").”
“OCA has read the ASF framework and has concluded that it will not object to continued status as a QSPE if Segment 2 subprime ARM loans are modified pursuant to the specific screening criteria in the ASF Framework,” stated the SEC’s January 8 letter to the AICPA and FEI.
“Additionally, given the unique nature of the contemplated modifications and other loss mitigation activities that are recommended in the ASF Framework, OCA expects registrants to provide sufficient disclosures in filings with the Commission regarding the impact that the ASF Framework has had on QSPEs that hold subprime ARM loans.”
The SEC also stated in its January 8 letter that its “represent[t] an interim step in addressing one practice issue that exists in the application of paragraphs 9(b) and 35-55 of Statement 140,” and that, “Concurrent with the issuance of this letter, OCA has requested the FASB to immediately address the issues that have arisen in the application of the QSPE guidance in Statement 140. OCA has requested that the FASB complete its project addressing the guidance in paragraphs 9(b) and 35-55 of Statement 140 in order to be effective no later than years beginning after December 31, 2008.”
Herz on Hindsight and Foresight
Rolling forward to yesterday’s board meeting, FASB Chairman Robert Herz observed, “I think the [QSPE] concept has been stretched and stretched and stretched and stretched and stretched over the years, and the crescendo has been with the latest round of very problematic assets that were securitized with this approach.”
He noted that although there are some very simple structures that would qualify for QSPE treatment, “the majority of what’s been an issue have been much larger things with assets that turned out to be quite problematic and require a lot of attention.”
“Maybe with the benefit of hindsight we understand that, although I think even with the benefit of foresight it could have been maybe understood.”
Herz’ observation about hindsight and foresight is interesting when read in conjunction with paragraphs 190 and 191 in the Basis for Conclusions section of FAS 140.
Para. 190 noted that constituents told FASB they believed QSPEs and their servicers should be able to exercise a “commercially reasonable and customary amount of discretion in deciding whether to dispose of assets in the specified circumstances,” and that “allowing a QSPE only to have provisions that require disposal without choice raises the risks of forcing a disposal at a bad time or that allowing no discretion conflicts with the fiduciary duties of the SPE’s trustee or servicer.”
“The Board acknowledged the concerns that underlie those views but did not change that provision,” continues para. 190, “reasoning that a qualifying SPE with that flexibility should not be considered to be a passive conduit through which its BIHs [Beneficial Interest Holders] own portions of its assets, as opposed to owning shares or obligations in an ordinary business enterprise.
Para. 191 noted, “The Board considered but rejected a general condition that would permit a qualifying SPE to sell assets as long as the sales were made “to avoid losses.” Such a condition would have allowed an SPE to have powers to sell as long as the primary objective was not to realize gains or maximize return, a concept introduced in Topic D-66. The Board rejected it because it would have given the trustee, servicer, or transferor considerable discretion in choosing whether or not the SPE should sell if a loss was threatened. Such discretion is more in keeping with being an ordinary business that manages its own assets than with being a passive repository of assets on behalf of others.”
It is always easier to look back with 20-20 hindsight, but it is interesting to observe the emphasis noted in FAS 140 as cited above on precluding QSPEs from operating like an ‘ordinary business,’ including the ability to use discretion and manage assets to avoid or minimize losses.
In light of the current credit crisis, it is encouraging to see the FASB responding rapidly to concerns that have been raised.
Companies, auditors and others will need to holistically examine the package of changes being proposed to remove the QSPE concept and the related amendments to paragraph 9 of FAS 140, to determine the net effect on how they account for securitization transactions, as well as the impact on how they are structured and any accounting ramifications from modification of underlying assets.
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