Securitization & Assets Sales

Usama Ashraf - CITChris Gill - GE Commercial Finance

Joseph P Sebik - J.P. Morgan Capital

SFAS140 Transfers of Financial Assets

Chris GillTechnical Accounting Leader

Capital Markets GroupGE Commercial Finance

FAS140 FrameworkFinancial components approach that focuses on control

– An entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished.

– Transfers of financial assets either sales vs.secured borrowings.

– A sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange.

FAS140 - What does it affectTransaction Structuring

• Need to recognize gain = need to isolate assets from transferor• QSPE can only hold certain types of assets• Complex modeling

Servicing• QSPE cannot make decisions only react in a programmed manner

to external events• Investors want same standard of care we apply to our assets• Must live by transaction documents for the life of the deal

Accounting• Accelerating income not creating it, Complex modeling of future

cash flows• Potential for gain reversals if taint isolation

Is it a FAS140 transactionUnfunded?• Seller funds never at risk • Seller name not on docs with

customer • Nothing to sell • Irrelevant• FAS91• Can offer unlimited recourse FIN

45 liability recorded

Funded?• Seller funds at risk• Seller name on docs with

customer• Sell down (participate or assign)• True Sale opinion required• FAS140 (Loans) FAS13 (Leases)• Can offer limited recourse

Financial AssetsFinancial Assets

– Receivables– Lease Rentals– Loans– Inventory Financing

Non-Financial Assets– Unguaranteed lease residuals– Operating Leases ( unless third party RVG purchased Day 1

Paragraph 9 Transferor surrenders control over transferred assets if and only if all of

the following conditions are met:– The 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. (Bankruptcy remote = True sale/ Non-Consolidation opinion)

– Each holder of its SPE beneficial interests has the right to pledge or exchange the beneficial interests it received, and no condition them from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor. (Only investors can decide what to do with the assets)

– The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (Transferor can’t ask for assets back)

Isolation is an ongoing test

What is a QSPE?A trust or other legal vehicle that meets all of the following conditions:a. It is demonstrably distinct from the transferorb. Its permitted activities (1) are significantly limited, (2) were entirely specified

and (3) may be significantly changed only with the approval of the holders of at least a majority of the third party beneficial interests

c. Can only hold limited types of financial assets.d. Limited powers to dispose of assets

Accept Servicer discretion is limited or pre-program decision making

What can’t a QSPE do?• Exceed the activities specified in the documents

• Can’t make decisions neither can its agents

• If need the QSPE needs to make decisions– Decisions must be hardwired into the documents so that the QSPE

(or its agents) respond in an automatic manner to external events.

What can a QSPE hold?(1) Financial assets transferred to it that are passive in nature (2) Passive derivative financial instruments that pertain to beneficial interests

issued or sold to parties other than the transferor, its affiliates, or its agents

(3) Financial assets that would reimburse it if others were to fail to adequately service financial assets transferred to it or to timely pay obligations due to it and that it entered into when it was established, when assets were transferred to it, or when beneficial interests were issued by the SPE

(4) Servicing rights related to financial assets that it holds(5) Temporarily, non-financial assets obtained in connection with the

collection of financial assets that it holds (6) Cash collected from assets that it holds and investments purchased with

that cash pending distribution to holders of beneficial interests that are appropriate for that purpose

Why is a QSPE important• Transfer is always considered under FAS140

• A QSPE is scoped out of FIN46R consolidated framework

• Lose QSPE status, subject to FIN46R consolidation.

• QSPE status is not permanent

FAS140 Accounting - Day 1 • Based on gain model PV of expected cash flows to/from the securitization

vehicle. – Importance of assumptions used in PV calculation

• Adjust carrying cost of assets sold for FAS91 and loss reserves.• Allocate carrying cost between assets sold and retained interests based on

their FV’s. • Recognize FAS140 gain on assets sold. • Create a Servicing Asset or Liability if Servicer compensation is not

adequate market compensation – (SFAS 156 changes Day 2 accounting)

• Retained Interest accounted for using FAS115 – Bifurcation required? SFAS155 Removes DIG Issue D-1 scope

exception for securitization beneficial interests

Day 1 ExampleCarrying Amount of Assets Sold

Principal Balance of Assets 664,000,000 Add Upfront Reserve Created 13,000,000 Accrued Interest 2,500,000 FAS 91 Deferrals and Fees 1,260,000 Less: Onbook Loss Reserve (1,660,000) Carrying Amount of Assets Sold 679,100,000

Net Proceeds From Securitization

Securitization Proceeds 662,000,000 Less: Transaction Expenses (2,600,000) Net Proceeds From Securitization 659,400,000

% Total AllocatedFair Value of Financial Components Fair Value Fair Value Carrying Amnt

Assets Securitized 662,000,000 95.32% 647,320,662 Reserve Releases 13,500,000 1.94% 13,200,648 I/O Strip 19,000,000 2.74% 18,578,690 Total 694,500,000 100.00% 679,100,000

Gain On Sale

Net Securitization Proceeds 659,400,000 Less: Carrying Amount of Sold Interests (647,320,662)

Pre-Tax Gain On Sale 12,079,338 #########Taxation (4,227,768) After-Tax Gain On Sale 7,851,569

SFAS140 Accounting - Day 2 Transferor Beneficial Interests

– Accrete I/O– Evaluate for Impairment under EITF 99-20 – If bifurcated mark bifurcated embedded to fair value

Servicing Asset or Liability– Amortize Day 1 balance or Fair Value

Other tasks– Evaluate ongoing isolation– Monitor Servicing activities– Investor Reporting

SFAS140 ED Transfer related Strengthen Isolation

– Attorney Opinions required– Consider all agreements made in relation to the transfer– All parties have unfettered right to pledge and exchange– Define when a QSPE has to be used

QSPE related– Tighten ability to rollover Beneficial Interests– Limits on asset types– Servicer discretion project – Loosen restrictions on derivative

But all up in the air now.Commence redeliberation in 3Q06

Portfolio Securitizations: Key Practical Implications

Usama AshrafSenior Vice President

Group Head, Strategic FinanceCIT Group Inc.

Introduction

• Securitization should fundamentally be viewed as a financing vehicle

• Given comparable financing costs through securitization vs. other financing alternatives, off-balance sheet securitizations only effect timing of income recognition, not total income recognized over the life of the transaction

• Regulatory and rating agency capital analysis generally relies on legal and economic substance of transaction vs. accounting treatment to capture risks retained– “Off-balance sheet” transaction for accounting does not automatically

qualify for more favorable capital treatment

“Gain” or “No Gain”

• Decision to treat securitizations as off-balance sheet carries significant consequences beyond recognition of upfront gain-on-sale– Periodic mark-to-market of retained interests (a.k.a. residual

interests/strips, I/Os, equity) in securitizations– Recognition of servicing asset (adequate compensation standard)– Assessment and validation of valuation assumptions (typically discount

rates, losses, prepayments and forward curves)– Potential impairment in retained interest values and related P&L impact– Potential limits on structural flexibility to comply with QSPE control

requirements– Appropriate financial modeling, accounting and internal controls

infrastructure to properly manage and report on deals on an ongoing basis

“Gain” or “No Gain”

• Financial reporting considerations– SEC disclosure – Management reporting and benchmarking

• Quality of earnings issues if gain-on-sale comprises significant portion of issuer’s income base– Treadmill effect– Rating agency concerns for issuers with rated debt– Investor reaction to diminished future earnings stream– Impact on equity market valuation

RI Valuation Considerations

• For off-balance sheet securitizations, assumptions used to value retained interest may not be tailored in order to force a zero gain

• Fair value of retained interests should be determined, at a minimum, on a quarterly basis

• If it is not practicable to estimate the fair value of a retained interest, it must be valued at zero– This situation is rare

• Fair value can be determined through either a market quote, or if a market quote is unavailable, through the use of a projected cash flow model – Model should utilize an approach and assumptions similar to what a

market participant would use to determine fair value

Source: Partially derived from Deloitte & Touche presentation to American Securitization Forum by Ann Kenyon, January 2006.

RI Valuation Considerations

• Fair value must follow a cash-out method – Identify the period in which cash becomes available to the issuer– PV each related cash flow at an assumed discount rate

• Impairment tests must be performed periodically to determine if an “other than temporary” reduction in fair value has occurred– Based upon application of EITF 99-20

Source: Derived from Deloitte & Touche presentation to American Securitization Forum by Ann Kenyon, January 2006.

Cash Flow Modelling Considerations

• Future collateral cash flows are projected, incorporating scheduled payments, prepayments, defaults, recoveries, forward curves, etc.

• Consider all the expected future obligations of the issuing SPE which could affect the priority, timing and amount of obligations of the trust

• Consider the amount and timing of the projected future cash flows to be received by the retained interest holder

• These retained interest cash flows are discounted back at the selected discount rate to determine the fair value of the related retained interest

Source: Partially derived from Deloitte & Touche presentation to American Securitization Forum by Ann Kenyon, January 2006.

Residuals and Operating Leases

• FAS 140 only addresses financial assets• Operating leases and unguaranteed lease residuals of capital leases are

out of scope• Possible to convert operating leases and unguaranteed residuals to

financial assets by purchasing residual value insurance at lease inception• Typical finance/capital lease securitization is structured as a two-step

transfer with bankruptcy remote entity in the first step retaining underlying equipment/collateral as well as any unguaranteed lease residuals

• Issuer consolidates first step entity for financial reporting purposes• Second step entity (QSPE in off-balance sheet structures) receives cash

flows from financial assets and retains first priority perfected security interest in underlying equipment/collateral

Typical Lease Securitization Structure

Lease 2006-1Owner Trust

Lease Funding Company, L.L.C.

(Depositor)

Owner Trustee

Indenture Trustee

Lease Group, Inc.(Servicer & Originator)

Leases & Equipment Reserve

Account

Equity Certificate

Leases & Security Interest in EquipmentCash

Cash

Cash (U

sed to

fund Prin

cipal &

Interest

Shortfalls

on the N

otes)

Investors

Servicing

Class A-1 Notes

Class A-3 Notes

Class A-2 Notes

Class B Notes

Class C Notes

Class D Notes

Class A-4 Notes

Discrete Transactions: Key Practical Implications

Joseph.P.SebikVice President

JP Morgan Chase & Co

Methods of Distributing and Funding Individual leasesIndividual leases may be syndicated, participated or discounted in a variety

of manners as a means of transferring some of the credit risks associated with the transaction– The terminology of the agreement must be clearly defined so that it is

understood which accounting announcement covers the transaction and so that the proper accounting is executed

• Syndication – A larger transaction is closed simultaneously with each lessor party possibly maintaining individual lease agreements with the lessee

• Participation - Where a lessor which owns the lease sells an ‘interest’ in a particular lease or component of a lease.

• Discounting of Lease Receivables - Issuing using non-recourse debt secured against the lease receivables

Syndication A Syndication is usually NOT subject to FAS 140 because the lead lessor is

not obligated to fund the entire lease and only their portion should be on their balance sheet

• A syndication is where the lessee agrees to maintain individual (legal) agreements with each lessor or lender.

• If at closing one party does not fulfill their obligation to fund their component of the lease, the lessee has no legal recourse to any of the other lessors– From a practical standpoint the other lessors may be pressured into

making up the difference• A lead lessor may have the ‘Master Lease’ in their name and individual

lessors may take an assignment of that Master Lease insofar as it relates to their individual lease schedules– The individual lease schedule when incorporated with the assigned

Master Lease forms the legal basis of the lease for that lessor

Syndication • The other lease schedules should not be recorded on the lead lessor’s

balance– If the lead lessor is the conduit of the funds, it may be acting in a trust

capacity– Usually with a syndication the individual lessors fund directly to the

seller of the assets • Theoretically a syndication fee collected by the lead lessor may possibly be

recognized as income under FAS 91, “Initial Direct Costs” provided the lead lessors yield is not different than the other investments; more often this is added to the lease yield

Participations• Participation - where an investor acquires an ‘undivided interest’ in a

particular lease or a component of a lease sold and is subject to FAS 140

• Often the lead lessor is underwriting the participation but seeking to close on it simultaneously so that they can mitigate their credit risk and exposure to the client or to the residual value– If the lessor is legally obligated to fund the lease, they must record the

lease on their balance sheet and thus any sale of receivable is subject to FAS 140 rules

– A lessor could avoid this by structuring the closing of a lease as a syndication, however the lessee bears the risk of a failed closing if one syndicate participant backs out of the transaction

Participations• The concept of FAS 140 is that a financial asset may be removed from the

balance sheet if three conditions are met:– The transfer is without recourse to the seller except for certain clean–

ups on large volume transactions – The transferer (seller) has surrendered control of the assets it has

transferred• The transferee (buyer) must be able to pledge or exchange the

assets without limitation– The buyer is legally isolated from seller such that even in a bankruptcy

of the seller the sale cannot be reversed by a bankruptcy court (wide jurisdiction is available to most bankruptcy courts) or the buyer cannot be consolidated with the seller

Participations (cont’d)• The accounting standard for a FAS 140 sale is a guideline for auditors to

ensure that the sale is not simply a collateralized loan

• Often it is advisable for the seller to obtain a ‘true sale’ opinion from counsel as a means of supporting the fact that the sale is without recourse, and in their legal opinion would not be reversed by a bankruptcy court – A true sale opinion requires counsel to examine the facts and

circumstances of the transaction and any representations and warrantees made by the seller to arrive at the true sales opinion

– An auditor may require a true sale opinion for the transfer to be treated as sale; if counsel cannot give a true sale opinion, then the transaction may be treated as a loan

Participations (cont’d)• A “two-step” sale is a legal way of isolating the asset from the original seller,

by transferring the asset into a bankruptcy remote entity, which although may be consolidated by the seller for accounting, would not enter bankruptcy even if the seller went bankrupt– In this manner the second step sale cannot be reversed by the bankruptcy

court since the SPE has not entered bankruptcy

• A “one-step’ sale is sale from the seller to a buyer and is often used for smaller transactions when legal counsel can provide (or theoretically provide) a true sale opinion since the sales “are in the normal course of the company’s business”

Participations (cont’d)• A participation of a lease receivable is usually subject to FAS 140 rules IF

the lease is a direct finance lease

– FAS 140 pertains to the transfers of financial assets, therefore only the sale of established lease receivables can be transferred off the balance sheet under FAS 140

– Even though sales of interests could include selling an interest in the lease receivables and the residual value, only the sale of the receivable is subject to FAS 140; the sale of the receivable is subject to FAS 13

Participations (cont’d)• Interpretations of FAS 140 along with FAS 13 regarding transfers of leases

– Sale of substantially all of Lease Receivables • If 90% or more of the lease receivable is sold, it is generally not

appropriate to continue to recognize any finance income the remaining lease component (the residual value)

– Build-To-Suit Projects • If the asset is under construction prior to a lease, even if the

construction is documented as if it is a lease, a lease receivable does not exist on the lessor’s balance sheet; rather the asset is ‘construction-in-process

– FAS 140 sale of receivables is sometimes considered when leveraged lease accounting cannot be achieved but when netting of the soldamount is important

• Sale of receivables achieves part of the leveraged lease balancesheet benefit

Discounting of Lease Receivables• Discounting of lease receivables is not subject to FAS 140

• If a lessor borrows against the receivables, even on a non-recourse basis whereby the buyer has no recourse to the seller and only has recourse to the lessee, such borrowing is treated as a loan

• The form may appear to be a sale of receivables because of the assignment of the receivables to the lender, but if legal counsel cannot provide a true-sale opinion, the transaction should be accounted for as a loan

• Operating lease receivables may be discounted and again the ‘seller’should treat the discounting as a loan, particularly since no receivables exist on the lessor’s balance sheet with an operating lease

• Discounting cannot be netted against a direct finance lease receivable

Questions