FASB rule baffles CDO market

The long-awaited guidance from the US Financial Accounting Standards Board (FASB) on financial reporting for special-purpose entities (SPEs) has failed to enlighten the structured finance community as to its implications on accounting for collateralised debt obligations (CDOs).

“After a long and tortuous process FASB did release this guidance, and it is very surprising to me that there is still very little certainty as to what it means,” says Alex Reyfman, a New York-based credit portfolio quantitative strategist at Goldman Sachs. “When it comes to CDOs, no-one seems to agree how this will be applied.”

There is one fundamental concern with the guidance: interpretation 46, as it is called, is applied to ‘variable interest entities’, and there is currently no agreement on whether CDOs fall into this category. According to the guidance, a variable interest entity has insufficient capital to conduct its business without additional financial support. Jim Mountain, partner with Deloitte and Touche’s securitisation group in New York, says that if the total equity investment is greater than a measure of its expected losses, it is excluded from interpretation 46 and is not considered a variable interest entity.

Currently, the assets and liabilities of an SPE don’t have to be consolidated if an independent third party makes an investment of at least 3% of the entity’s total capital. But the new FASB guidance increases the minimum required equity in SPEs held by third-party investors to 10%. This new rule threatens the off-balance-sheet treatment CDO collateral managers currently receive. If less than 10% of the equity is sold to outside investors, the CDO is viewed as a subsidiary of the collateral manager and the assets of the deal are consolidated on to the manager’s balance sheet. In a CDO, the equity is the non-rated, highest-yielding and riskiest tranche of the notes, and is arguably the most difficult to place.

Even if a CDO is deemed to have sufficient equity to cover suspected losses, it may still be termed a variable interest entity and be subject to consolidating accounting if the equity holders as a group lack the ability to make decisions about the activities of the entity. Paul Forrester, a securities lawyer involved in CDOs at Mayer, Brown, Rowe & Maye in Chicago, says this clause may trip up many typically structured managed CDOs. Consequently some collateral managers may try to restructure existing transactions, for example by modifying the voting provisions to avoid compliance with the ruling, says Deloitte and Touche’s Mountain.

Tip of the iceberg

Reyfman says the debate over whether CDOs are actually variable interest entities is just the tip of the iceberg. “If you get into the detail there are dozens of questions that are unresolved in people’s minds,” he says. At present, there is considerable uncertainty looming over the interpretation of the rules. “Practice will have to re-evolve as accountants and firms make calls about what this means and how it should be interpreted and applied,” he says. “I think it’s entirely possible that at least initially similar deals will produce different accounting outcomes based on which accounting firm is doing the work.”

So far this year, visible primary issuance in the CDO market has been low. And market participants as yet are unsure as to whether initial fears that the FASB’s rules will kill the CDO market will be played out. But some CDO strategists are more bullish about the effect of the ruling on CDO issuance this year. Lang Gibson, director of structured credit products research at Banc of America Securities in New York, said in a recent research report that any negative impact on CDO managers’ balance sheets will be short-lived.

“The biggest impediment to volumes has been lack of demand rather than supply and there are plenty of issuers out there ready to meet demand,” he added. “A partial withdrawal would have little impact on closed volume for 2003.”