A Big 4 auditor told a FASB roundtable yesterday that his firm is applying ‘an abundance of caution’ in determining the impact of any implicit obligations of banks or other issuers in connection with off-balance sheet vehicles. The roundtable was convened by FASB for feedback on its proposed changes to securitization and related consolidation standards, including the Proposed amendment to FAS 140, and Proposed amendment to FIN 46R.
Among the proposed changes are removal of the concept of Qualified Special Purpose Entities (QSPEs), a structure used to obtain off-balance-sheet treatment for certain mortgage and other securitizations; this change has been reported to potentially add back trillions of dollars of mortgage-related and other assets to financial institutions and others. The proposed effective date for these changes is 2010.
Included among the panelists at FASB’s roundtable yesterday were auditors, issuers and investors as well as SEC Deputy Chief Accountant Jim Kroeker and representatives of the Federal Reserve, Fannie Mae, Freddie Mac, the American Securitization Forum, CFA Institute, and others.
The comment deadline on the proposed amendments to the securitization rules is November 14; FASB Technical Director Russell Golden said they are anxiously awaiting comments and will move rapidly to redeliberate the proposals. Separately, he noted that FASB would begin redeliberations next week on the separate proposal containing disclosures that may be required as early as this year-end (Proposed FSP FAS 140-e and FIN 46R-e ); the comment deadline on the disclosure proposal was October 15.
Implied Obligations; Abundance of Caution
One panelist asked, “If you are an SEC registrant, don’t you have an obligation if there is an intention to potentially support obligations, aren’t you misleading investors if you don’t disclose the possibility of that, under a 10b-5 test of omitting information?” (Reference to Rule 10b-5 of the Securities Act of 1934.)
SEC’s Kroeker, providing the usual disclaimer he was speaking only for himself, noted, “I’m not a securities attorney nor do I practice as an attorney at the Commission.” However, he added, “MD&A has significant requirements for disclosure; when you cross that threshold for actions you may take but are not committed to take, I leave that to attorneys.”
FASB’s Golden asked what kind of evidence auditors look to now under the current requirement in FIN 46R to consider implicit arrangements.
KPMG Partner Kimber Bascom replied that besides rep letters (letters of representation signed by management), “You can look to other things, the economics of situations.”
“Out of an abundance of caution,” said Bascom, “we have concluded the literature drives us, once you have taken an action you did not have to take, we conclude you have taken on all that type of risk.” He added, “If I think you are going to step in and provide support, the conclusion about accounting isn’t being driven by the preparer but by the auditor,” acknowledging that is not the way the system is supposed to work (i.e. it is management or the preparer that takes responsibility for the financial statements).
Disclosures May Be Required This Year
Panelists at the roundtable debated whether it was feasible to provide all the proposed disclosures FASB is looking for by this year-end, particularly given other requirements set to take effect this year-end on disclosures of credit derivatives and certain guarantees (set forth in FSP FAS 133-1 and FIN 45-4, and FAS 163). Some panelists suggested moving the effective date of the proposed securitization disclosures to first quarter 2009 instead of year-end 2008.
Challenges noted included access to information that may reside with third parties, and the sheer volume of information. A number of panelists noted it takes time to build and test “SOX compliant” systems to collect the data to comply with new disclosure requirements (i.e. referencing the internal control reporting requirements set forth in Section 404 of the Sarbanes-Oxley Act.)
Views on how soon the expanded disclosures were needed, and how expansive they should be, varied. One panelist said, “I think if you are engaged in an activity that is rather complex, as a potential investor or current investor… my need for information [increases] … pile it on.”
FASB board member Larry Smith said, “From my days as an auditor, at some companies I was on, we would have reams and reams of paper to explain the judgments we made.” He added, “I think what we are asking for is impossible, we need to get practical in what you are asking preparers to explain.” He discussed, in particular, practical challenges to providing a sensitivity analysis when there are many interdependent factors, and questioned if a generic or boilerplate disclosure would be useful.
To address concerns about timing of the new disclosures, FASB staff may meet with investors and issuers to determine which of the proposed disclosures are most important to users of financial statements, and which are practicable vs. impracticable for preparers of financial statements to provide, in terms of year-end reporting.
Accounting Changes, Including Removal of QSPEs
Separately, the proposed changes that would impact how securitizations and certain other transfers of assets are treated in the financial statements would take effect in 2010. As background, the accounting exception currently provided in Generally Accepted Accounting Principles (GAAP), specifically in FAS 140 and FIN 46R, permits off-balance-sheet or ‘sale’ treatment for QSPEs based on a presumption that QSPEs would be passive vehicles – not actively managed.
However, the subprime mortgage crisis – unforeseen when FAS 140 and FIN 46R were written, and by all accounts, unforeseen by most everyone - resulted in calls for modifications of mortgages to help borrowers avoid foreclosure and default. Questions arose last year about permissible activities in QSPEs, including loan modifications, in order to not threaten sale treatment under GAAP.
Last year, Rep. Barney Frank (D-MA), chair of the House Financial Services Committee, asked the SEC for a clarification as to whether FAS 140 prohibited mortgage modifications when default was ‘reasonably foreseeable’ but had not actually occurred. SEC Chairman Christopher Cox responded with a letter (see SEC letter to Rep. Frank) that effectively said there was no such prohibition in FAS 140, but detailed in an attachment by Chief Accountant Conrad Hewitt that reference should be made to FAS 140’s discussion of what constitutes a ‘passive’ trust. Some questioned how to interpret the SEC’s letter; see related Center for Audit Quality (CAQ) Alert, citing a letter sent by Sen. Charles Schumer (D-NY) to the Big 4. As the mortgage crisis deepened and actions to try to stem the crisis accelerated, the American Securitization Forum (ASF) issued a streamlined framework for mortgage modifications (see ASF Framework), and the SEC sent a letter to the American Institute of CPAs (AICPA) and Financial Executives International (FEI) in January, 2008, stating the SEC “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.” (See SEC letter to AICPA and FEI.
As has become increasingly evident over time, the power to arrange mortgage modifications appears to have been heavily restricted by the legal terms of the securitization trusts, separate and apart from any accounting considerations. For example, requirements set forth in trust’s governing documents may require obtaining the approval of a majority of a trust’s shareholders or investors for any changes to the terms and powers of the trust and parties under the trust, including, potentially, the powers of the servicer or other parties to modify the underlying mortgages. Recent events this fall, including the taking into conservatorship of Fannie Mae and Freddie Mac, and FDIC take-overs of failed banks, may provide more ability to get past some of these roadblocks to modifications, as reported in the article, “GSEs May Be Forced to Deal on Loan Mods” by Joe Adler and Emily Flitter in the American Banker on Sept. 10. More recently, the Emergency Economic Stabilization Act of 2008 (EESA) signed into law on Oct. 3 provides funding and new powers for government action to stem the crisis.
Some panelists at the roundtable yesterday asked FASB to hold off making any change to the securitization and consolidation rules pending completion of the FASB-IASB joint project on consolidations, so companies wouldn’t be asked to change twice. (Additionally, investors would have a more comparable stream of information.)
Alan Teixeira of the IASB staff said the IASB expects to release their Exposure Draft on consolidation this month, noting they were also trying to be responsive to a request of the Financial Stability Forum to focus on this issue. FASB Chairman Robert Herz pointed out that the scope of IASB’s upcoming proposal was broader than the scope of the present FASB proposal, with the IASB addressing consolidation of voting interest entities as well as variable interest entities; therefore further consideration would be required before FASB could converge to that standard.
After users on the panel commented, SEC’s Kroeker observed, “We heard clearly from users around this table” about concerns with waiting until 2011 for completion of the joint FASB-IASB project on consolidation accounting, since that timing could stretch as a practical matter to 2012, 2013, with additional time provided before the standard becomes effective, adding up potentially to a total of 5-6 years from now.
Freddie Mac estimated the cost for them to implement the proposed changes to the securitization standards would be $55 million dollars, and would take 18 months to implement, said panelist Tim Kviz. (Also cited in Freddie Mac's comment letter.) Kviz noted, “For 12 million loans we guarantee, very few of those are on our balance sheet, they are not our loans, to get access to that information requires changes to our contracts, that can’t be done over night, might have to wait till end of term [of each contract, which], could be a year.” He continued, “to have to turn around and do it again for a potentially different model in IFRS, I don’t see the benefit in that.”
FASB Chairman Robert Herz noted it is ultimately the investors, not the company that bears the cost of obtaining the information. Investor panelist Tony Sondhi indicated the money spent to implement these changes would be worthwhile, even if it would result in a disclosure package as big as the Manhattan telephone book, which, he noted, he found very useful when he lived in Manhattan. FASB board member Larry Smith later commented, “I don’t know how you marry information for users on a disaggregated basis, vs. the number of assets that are going to be consolidated; never mind the Manhattan phone book, you’ll get the whole northeast phone book.”
Additional highlights from the roundtable, including a discussion of a linked presentation model, comments on use of examples, and issues relating to private companies can be found in this FEI Summary. If you’d like to receive our blog by email, sign up here.
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