christopher bianucci partner [email protected] (312) 879-2040 ernst & young llp 233...

Christopher Bianucci

Partner

[email protected]

(312) 879-2040

Ernst & Young LLP

233 South Wacker Drive

Chicago, IL 60606

2003 Interagency Accounting Seminar

Asset Securitization

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FASB Interpretation 46

Consolidation of VariableInterest Entities (“VIEs”)

March 20, 2003

Christopher BianucciPartner

(312) [email protected]

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Accounting OverviewAccounting Overview

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Accounting OverviewAccounting OverviewAccounting OverviewAccounting Overview

Statement of Accounting Standard No. 125 (issued in 1996) revised criteria for accounting for sales of financial assets and securitizations.

• SFAS 125 introduced financial components approach and based balance sheet treatment on a control basis.

Adoption of SFAS 125 gave rise to need for 2-step transfers and “Qualifying” SPEs in order to achieve true sale criteria

SFAS 140 retained the fundamental concepts of SFAS 125 and clarified certain QSPE issues. Also expanded the disclosure requirements.

FIN 46, released in 2003, revised the framework for determining consolidation of variable interest entities.

Accounting for Securitizations… The Saga Continues

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Sales Criteria

Surrender of control critical criteria. Paragraph 9 of SFAS 140 provides guidance on how to interpret a transaction for purposes of determining whether sales treatment is appropriate.\

Must meet all of the following:

9(a) Transferred assets have been isolated from the transferor -- put presumptively beyond the reach of the transferor and its creditors even in bankruptcy or other receivership

Generally, legal opinions will be required

9(b) Transferee obtains the right -- free of conditions -- to pledge or exchange the transferred assets or the transferee is a qualifying SPE and the holders of beneficial interests in that entity have the right -- free of conditions --- to pledge or exchange those interests and such pledge or exchange does not provide more than a trivial benefit to the transferor.

Effect: Seller cannot restrict buyer’s ability to sell the transferred assets

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Sales Criteria (continued)

9 c 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 transferred assets before their maturity, or

• The ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (this could have a significant impact on deals with a revolving structure due to removal of accounts provisions (ROAPs)

Limited randomly selected accounts Response to third party-controlled event Defaulted contracts

Effect: No Call options on unique assets

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Consolidation Considerations

Deconsolidation achieved in 2 ways:

• QSPE

• FIN 46 – applies to special purpose entities which do not meet the criteria of QSPE.

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QSPE

Qualified Special Purpose Entity (QSPE): QSPE can be corporation, partnership, or trust.

QSPE’s can only hold• Passive financial assets transferred to it• Passive derivative financial instruments• Servicing rights related to the assets it holds

Activities of QSPE must be limited, specified in the documents that create it, and can only be changed by a majority of the 3rd party beneficial interest holders

Must be “demonstrably distinct”• At least 10% of its beneficial interests held by parties other

than the transferor, its affiliates or agents

QSPE can only sell or dispose of noncash financial assets as an automatic response to a restricted list of conditions (servicing becomes very restricted)

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Entity that by design has:

• Equity investment at risk not sufficient to finance its activities without additional financial support (5(a)), or

• Equity investors do not have either-

Direct or indirect ability to make decisions through voting or similar rights (5(b)(1)),

Obligation to absorb expected losses (5(b)(2)), or

Right to receive residual returns (5(b)(3))


What is a Variable Interest Entity?

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Is the total equity investment at risk sufficient?

Do equity investors have the ability to make decisions about theentity’s activities through voting or similar rights?

Do equity investors have the obligation to absorb expected losses ?

Do equity investors have the right to receive the expected residual returns if they occur?

VIE Decision Tree

yes

yes

yes

yes

Apply consolidation guidance of FAS 94 Entity is a VIE

No

No

No

No

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At least equal to expected losses

At least 10% of assets, unless:

• Entity can finance activities without additional subordinated financial support (9(a)),

• Entity has at least as much equity as other entities that hold similar amounts of similar quality assets, and operate with no additional subordinated financial support (9(b)), or

• Investment exceeds expected entity losses based on reasonable quantitative evidence (9(c))


How Much is Enough?

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Contractual, ownership, or other pecuniary interests that change with changes in VIE net assets (paragraph 2(c))

Includes:

Equity and subordinated debt instruments issued by VIE

Senior Debt instruments

Loss guarantees

Servicing/Management contracts

other


What Constitutes a Variable Interest?

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The Primary Beneficiary of a VIE is the entity that is deemed to be the accounting parent and consolidates the VIE.

Entitled to more than 50% of expected VIE: • Losses, or • Residual returns

If different parties meet criteria, losses take precedence


How do I know if I have to consolidate something?

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Does the entity absorb a majority of VIE’s expected losses?

Does entity receive a majority of residual returns and no other entity absorbs a majority of expected losses?

No

No

Entity is not PB – Do not consolidate VIE Entity is PB – Consolidate VIE

Yes

Yes

Primary Beneficiary Decision Tree

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Derived from expected cash flows, discounted and adjusted for market factors and assumptions (paragraph 2(b))

Includes:

• Expected variability in: Net income or loss, Fair value of assets if not included in prior item, and

• Fees to: Decision makers, and Guarantors of substantially all VIE assets or liabilities (paragraph 8)

Decision maker directly or indirectly makes decisions that significantly affect VIE results (paragraph 14)


Expected Losses Defined

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How about an Example….


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VIE Variable Interest: Purch. Price ComputedPrincipal (Fair Value) Yield

Senior (zero coupon) 750,000$ 675,000$ 7.26%

Subordinate (zero coupon) 210,000 28,000 10.71%960,000 703,000 7.40%

Management Fee (annual) 40,000 40,000 0.00%1,000,000$ 743,000$ 7.00%


Assumptions:

Assume a pool of assets with a maturity of 1 year, funded by the following structure:

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Assumptions:

The pool of financial assets, with a contractual cash flow of $1.0, have expected cash flows as follows:

Outflow To Net VIE Outflow, ExcludingProbability In Flow Management Fee Senior VI Subordinate VI Cash Flow Management Fee

(a) (b) (c) (d) (e) (f)=(b)-(c)-(d)-(e) (g)=(d)+(e)5% 650,000$ 40,000$ 610,000$ -$ -$ 610,000$

10% 700,000 40,000 660,000 - - 660,000 25% 750,000 40,000 710,000 - - 710,000 25% 800,000 40,000 750,000 10,000 - 760,000 20% 850,000 40,000 750,000 60,000 - 810,000 15% 900,000 40,000 750,000 110,000 - 860,000

Present Value at 6.00% 37,736$

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Computed Variability of Senior Interest

Cash Flow Computations Variability in ExpectedCash Flow Probability Profit and Loss

Amount Probability Weighted Fair Value Present Value (Loss) Profit(a) (b) (c)=(a)*(b) (d)=Purchase Price (e)=(a)/(1+yield) (f)=((e)-FV)*(b))

610,000$ 5% 30,500$ 568,715$ (5,314)$ - 660,000 10% 66,000 615,331 (5,967) - 710,000 25% 177,500 661,948 (3,263) - 750,000 25% 187,500 699,240 - 6,060 750,000 20% 150,000 699,240 - 4,848 750,000 15% 112,500 699,240 - 3,636

100% 724,000$ 675,000$ (14,544)$ 14,544$

Computed Yield 7.26%

(675,000)$ 724,000$

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Variability of Subordinated Interest

Cash Flow Computations Variability in ExpectedCash Flow Probability Profit and Loss

Amount Probability Weighted Fair Value Present Value (Loss) Profit(a) (b) (c)=(a)*(b) (d)=Purchase Price (e)=(a)/(1+yield) (f)=((e)-FV)*(b))

-$ 5% -$ -$ (1,400) - - 10% - - (2,800) - - 25% - - (7,000) -

10,000 25% 2,500 9,032 (4,742) - 60,000 20% 12,000 54,194 - 5,239

110,000 15% 16,500 99,355 - 10,703 100% 31,000 28,000$ (15,942)$ 15,942$

Computed Yield 10.71%

(28,000)$ 31,000$

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Variable Interest Decision MakerLosses Profit

Dollars % Dollars %

Manager -$ 0% 37,736$ 55%

Senior (14,544) 48% 14,544 21%

Subordinate (15,942) 52% 15,942 23%

Total (30,486)$ 100% 68,222$ 100%

Total - Computed Yield (26,072)$ 63,807$

Determination of Primary Beneficiary


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Only if:

• Governing documents or contractual arrangements change,

• Part or all of equity investment is returned, and parties other than equity holders become exposed to expected losses, or

• Entity undertakes additional activities or acquires additional assets that increase expected losses

Not if losses exceed expected losses and reduce equity investment


Reconsideration of VIE Status paragraph 7

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Non-primary beneficiary reconsiders if it’s primary beneficiary only if:

• Governing documents or contractual arrangements change,• Contractual arrangements among parties change,• Acquires newly issued variable interests, or• A portion of former primary beneficiary’s interest

Primary beneficiary reconsiders if it is primary beneficiary only when it sells or disposes of all or part of its variable interest


Reconsideration of Primary Beneficiary Status paragraph 15

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If consolidation of a VIE is required:

• Record assets of VIE at Fair Value (other than those transferred by the PB)• Record assets transferred by the PB at Book Value• Record Fair Value of liabilities assumed• Record Fair Value of minority interests in the VIE

If debit balance, record as extraordinary loss If credit balance, reallocate to basis of assets

If Consolidation is required

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If reasonably possible a VIE will be consolidated or disclosed upon full implementation:

• Nature, purpose, size, and activities of VIE, and• Maximum loss exposure from involvement

VIEs can be aggregated if separate reporting would not add material information


Pre-Implementation Disclosure paragraph 26

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Pre-Implementation Disclosure:• Financials issued after January 31, 2003

VIEs created after January 31, 2003:• Immediately

VIEs created before February 1, 2003 whose primary beneficiary is a public company:• Quarters beginning after June 15, 2003


Timing

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Measure assets, liabilities and non-controlling equity in VIE at carrying amounts as if the Interpretation had been in effect as of the date enterprise first met the requirements to be the PB – if practicable to do so. If not practical to determine previous carrying value, record at fair value as of effective date.

Any difference between the net assets of the VIE and the previously recognized interest shall be recognized as a cumulative effect of an accounting change. Restatement of previous financial statements is encouraged but not required.

Transition Provisions – existing transactions

christopher bianucci partner [email protected] (312) 879-2040 ernst & young llp 233...

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