The financial crisis rammed home that transferring assets from the balance sheet of a financial institution to a special-purpose entity does not necessarily isolate that firm from risk. Worried about the reputational risk that could arise from the failure of structured investment vehicles (SIVs) they had sponsored, several banks consolidated billions of dollars worth of assets on to their balance sheets in 2007 and 2008 - much to the surprise of their investors. For the most part, this exposure was not included in any disclosures made by the banks prior to consolidation, nor was any analysis of the potential risks conducted internally.
Under pressure from regulators, the accounting standards bodies started looking at their rules for the transfer of financial assets last year. And after a lengthy consultation period, the US Financial Accounting Standards Board (FASB) published its revised guidelines on June 12, set to come into effect from 2010.
The two rules are FASB Statement (FAS) 166, which covers accounting for transfers of financial assets and revises the existing FAS 140, and FAS 167, an amendment to FASB Interpretation (Fin) 46, which covers the consolidation of variable interest entities.
The new rules are far-reaching. For a start, FAS 166 removes the concept of qualifying special-purpose entities (QSPE) - essentially, bankruptcy-remote vehicles that were exempt from consolidation under FAS 140. On top of that, the new rule restricts when a company can transfer a portion of a financial asset and account for that transferred portion as being sold. Under the new rules, the transfer of a portion of a financial asset "may be reported as a sale only when that transferred portion is a pro rata portion of an entire financial asset, no portion is subordinate to another, and other restrictive criteria are met". Companies must also provide additional disclosure about any ongoing involvement with transferred assets - for example, guarantee arrangements, servicing agreements and derivatives.
Meanwhile, FAS 167 tightens up the existing Fin 46, itself introduced in 2003 to prevent abuses in the accounting of special-purpose vehicles. Under current rules, a company must consolidate any entity in which it has a controlling interest. This has been tweaked under FAS 167 to require firms to consolidate variable interest entities if they have control over "the most significant activities" of the vehicle, and the right to receive benefits or obligation to absorb losses. Companies must also review their assessments regularly, and provide additional disclosure about any involvement with variable interest entities and any significant changes in risk exposure.
The FASB points out a lack of ongoing assessment and disclosure had been a particular problem during the credit crisis, causing waves of unexpected writedowns: "Under existing guidance, as expected credit losses increased significantly due to unpredicted market events, some companies did not reconsider whether they should consolidate a variable interest entity."
Taken together, the changes could lead to huge amounts of assets coming back on bank balance sheets. According to the Securities Industry and Financial Markets Association, there were $2.6 trillion of asset-backed securities outstanding at the end of March 2009 (see figure 1). The Federal Reserve estimates the new rules will force US banks to bring around $900 billion of assets back on balance sheet. This would mean risk-weighted assets increase by $700 billion.
This will fall chiefly on the larger banks - in particular, the 19 financial institutions that had to perform stress tests as part of the US Treasury's Supervisory Capital Assessment Program (Scap). Banks participating in the stress tests were asked to estimate their losses and revenues under two scenarios: a baseline case and a more adverse scenario. In both, the banks were told to assume the FASB changes would come into effect in 2010. The Fed's $700 billion estimate is based on the data submitted by the banks as part of the Scap.
"I think the Fed's figure is not an unreasonable estimate at this point. It applies to the 19 Scap institutions - those are the institutions that will have the bulk of assets coming on balance sheet," says Sharon Haas, managing director in the financial institutions group at Fitch Ratings in New York.
Others are not so sure. George Miller, executive director at the American Securitization Forum (ASF), believes the Fed's figure underestimates the extent of the change. "Most people in the industry believe that significantly understates the magnitude. When you're talking about $1 trillion or something in excess of that, it has a significant impact," he argues.
At the very least, analysts agree a precise figure is difficult to pin down at the moment. "It's difficult to say what the net impact will be. In every different structure, there are different pieces held with different risk weightings. A residential mortgage would be 20% risk-weighted, credit card debts are 100% risk-weighted and some conduits have even more than 100%, so to go through thousands of vehicles and figure out the net impact would be almost impossible at this point," says Meghan Crowe, a senior director in the financial institutions team at Fitch Ratings in New York.
Additional risk-weighted assets on balance sheet may require banks to hold more capital. Using data from the Scap, the 19 participating financial institutions had a total of $7.8 trillion in risk-weighted assets. Assuming the Fed's estimate is correct, and banks would aim to keep their Tier I capital ratios constant at an average of 10.7%, this would mean the accounting change alone would force financial institutions to raise $74.9 billion in capital. That is slightly more than the $74.6 billion additional capital buffer required by US regulators as a result of the stress tests - a figure that is supposed to take into account losses and reduced revenues, as well as assets coming on to the balance sheet as a result of changes to FAS 140.
But this is a misleading way of looking at the situation. Few of the Scap banks have revealed the effects of the change on their balance sheets, but those that have show there is no relation between the impact of the accounting changes and the requirement for additional capital at the level of the individual bank. JP Morgan estimated in April that FAS 166 and 167 would force it to take $145 billion of assets on to its balance sheet - $62 billion after risk weighting - but the Scap test found it did not need additional capital.
In fact, many banks have been setting aside capital to cover assets held in off-balance-sheet vehicles for some time, even if they have not yet consolidated those assets. For instance, Citigroup would have to move $165.8 billion of assets on to its balance sheet as a result of the new FASB rules, but has already included $82 billion of them in its capital ratio calculations.
"A lot of these assets were coming on balance sheet even before the rule changes, because there had been credit deterioration and issuers have had to add credit enhancement. And some issuers have been downgraded and so require more capital as they become riskier. Accounting changes and credit changes are working together for some assets, but, on balance, credit deterioration is clearly the driver, supplemented at the margin by accounting changes," notes Crowe of Fitch Ratings.
Certainly, banks have had long enough to prepare for these changes. The rules were initially intended to come into force in November 2008, but the FASB announced a 12-month delay last July. Despite this, industry groups lobbied hard in June this year to delay the launch again, with a number of financial industry bodies, including the US Chamber of Commerce and the Mortgage Bankers Association, calling for a further grace period - which, ultimately, they did not receive.
Industry groups point to a possible chilling effect on lending as a good reason to delay changing the rules. Tightening the regulations on off-balance-sheet vehicles will make securitisation less attractive, they claim, reducing the amount of loan origination and available capital and thus slowing economic growth.
"What will this do to the ability of banks to lend and finance assets and let the economy grow? Securitisation in the US has funded 50% of consumer lending. If it becomes more difficult to do that, it's not clear where the capacity will come from, and that will have a significant adverse impact on the economy," says the ASF's Miller. "Legislation like this is making it more difficult to free capital. You have to have a trade-off between efforts to promote stability and transparency versus economic growth, and at some point these things are incompatible."
Michael Gullette, a vice-president in charge of accounting and financial management at the American Bankers Association (ABA), agrees: "If the result of the capital regulations is to put on more capital, it would tend to slow securitisation as there would be no incentive - or not as much - to securitise."
The indiscriminate nature of the rules has also been criticised. The majority of problems occurred in the SIV arena, which tended to issue short-term commercial paper and medium-term notes to finance the purchase of long-dated assets, including collateralised debt obligations of asset-backed securities. Many other segments of the securitisation market have held up relatively well in comparison, argue industry groups.
"There have been broad statements about off-balance-sheet entities and sponsors that have had to rescue them. It seems to me these cases are mainly prevalent in certain limited sectors, such as SIVs and other arbitrage vehicles, and are not actually heard of in more vanilla securities that have been the lifeblood of consumer finance companies," says Miller.
However, some analysts dispute the claim that the changes will have a dramatic effect on lending. According to analysis published in June by the Federal Reserve Bank of St Louis, lending dropped sharply in late 2008 - and although it is difficult to disentangle supply constraints from lack of demand, the report notes lower demand for credit seems to have played a role. And the most recent Fed survey of senior bank loan officers, conducted in April this year, found both continuing tightening of lending standards and a continuing fall in demand for "nearly all types of loans".
Lack of demand
Dina Maher, senior director in the credit policy group at Fitch Ratings in New York, agrees there are many factors at play, including a lack of demand for new loans from consumers, high default rates and absence of interest from investors in new securitisation transactions. "The underlying instruments being put into these vehicles are under severe stress. Take commercial mortgage-backed securities: there hasn't been a new deal issued in some time, and that's certainly not an accounting issue - it's driven by the poor investor appetite for commercial real estate loans," she says.
Haas of Fitch elaborates on the point: "The accounting change is not a serious concern, although it may have some validity at the margins. There are a number of factors that affect banks' ability and willingness to lend. The first and the most influential is the equilibrium between creditworthy borrowers who have a demand for credit and banks' appetites, in terms of which borrowers they want to lend to. The strongest borrowers are not showing considerable demand now and, frankly, a lot of the demand out there is in risk categories the banks are trying to keep a low appetite for."
In fact, the new rules are praised by some for bringing accounting standards in the US and Europe closer together. The FASB and International Accounting Standards Board (IASB) have been working to develop a common set of accounting rules, with the IASB recently moving much closer to the US standard on fair-value accounting. FAS 166 and 167 would eliminate the concept of the QSPE, which does not exist in International Financial Reporting Standards (IFRS).
"This brings US Generally Accepted Accounting Principles a lot closer to IFRS. The way IFRS looks at the question of power and control is similar to the new regulations. There might be some difference on the margins, but in practice it comes fairly close," says Maher.
But industry representatives say the difference is still substantial, and closing it - once IASB completes its own exercise on revising off-balance-sheet rules, under way at the moment - could require another round of reform by FASB. "Most US respondents to the FASB draft wanted to wait and do it together with the international project, but the FASB went ahead with it anyway. There's a fear of spending time complying with these rules and then having them change again in two years' time," says the ABA's Gullette.
Ultimately, the new rules will change the way banks use off-balance-sheet vehicles and reduce the volume of assets that can be derecognised. It will also bring greater disclosure and transparency over the assets that are placed in special-purpose vehicles.
However, the FASB guidelines are unlikely to completely halt abuses in the treatment of off-balance-sheet vehicles, says Maher.
"As with any new standard, everyone will be looking for a loophole. It looks like if you can't identify the primary beneficiary of an asset - if it's shared by multiple parties, and you can't identify which one has the power to direct the activities of the asset - then no-one consolidates it. It's possible that investment banks will be looking for a way to structure things so no-one can identify the primary beneficiary."
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