By Nathan Abegg, senior manager at Deloitte & Touche LLP
CDOs come in a variety of shapes and sizes, ranging from static pool vehicles with little changes in collateral composition to very actively managed vehicles. When creating these structures, using GAAP accounting analysis is required in order to determine consolidation consequences, if any, for the participating parties (including transferors, investors and the asset manager). For accounting purposes, such vehicles are either a QSPE, VIE or VoIE. This article explores the differences in these entities and evaluates some advantages and disadvantages of each, in relation to the market motivations of investors and asset managers.
The challenges of being a qualifying special-purpose entity:
QSPEs are defined in FASB No. 140, "accounting for transfers and servicing of financial assets and extinguishments of liabilities." The accounting advantage of a QSPE is that the assets and liabilities of a QSPE are never consolidated by the transferor and also are not consolidated by third party investors in the vehicle, except in unusual circumstances. Characteristics of a CDO vehicle that qualify it as a QSPE include: a) the vehicle is distinct (as defined in Statement 140) from the party from which it received its underlying assets; b) its permitted activities are significantly limited and entirely specified in the legal documents used to establish the vehicle; c) the financial assets it holds are "passive"; and d) the vehicle cannot sell or dispose of its financial assets except as an automatic response to a set of limited circumstances.
These rules impact what assets a QSPE can hold the maximum notional amount of its hedges, and the discretion an asset manager can have over managing assets with credit concerns (very little unless the discretion is exercised in connection with a "servicing activity"), among other things. For example, a QSPE cannot hold securities with voting rights if it retains the right to choose how to vote (not deemed to be a "passive financial asset"), nor can it enter into credit default swaps (generally not deemed to be a "passive derivative" that counteracts risks that the beneficial interest holders have). Also, it can only hold "passive" (i.e., no decisions are required, such as a decision to exercise an option) derivatives such as vanilla interest rate swaps, and the notional amount of its derivatives cannot exceed, nor be expected to exceed, the amount of securities issued by the QSPE and held by investors unrelated to the vehicle's transferor.
The most complex restrictions relate to a QSPE's ability to sell assets. A QSPE can only sell assets in an automatic response to one of several conditions. A QSPE may sell assets:
In response to an event or condition that is: a) specified in the legal documents; b) beyond the control of the transferor or its affiliates and agents; and c) causes, or is expected to cause, the fair value of the assets to decline by a specified degree below their fair value when first obtained by the QSPE.
In response to the exercise by a holder of a security issued by the QSPE of its right to put back its interest to the QSPE, so long as such holder is not the transferor or an affiliate or agent of the transferor.
Upon its termination or the maturity of its issued securities on a fixed or determinable date that is specified at the inception of the QSPE.
Although not often seen in CDOs but common in credit card securitizations, in response to the exercise by the transferor of a call or "removal of accounts provision" that is specified in the legal documents that established the QSPE and is exercisable only upon the occurrence of an event outside of the transferor's control (i.e., a credit card debtor defaults).
Because of these restrictions and requirements, QSPEs are not suitable vehicles for many CDOs. Even upon the occurrence of specified disposition events that a) adversely affect the assets and that b) are beyond the asset manager's control, the asset manager does not have full decision-making power; it must dispose of the affected assets. These predetermined conditions, which must be disclosed in the legal documents at closing, could include a rating downgrade below a minimum level, a decline in fair value below the value of the asset when it was transferred to the QSPE and an obligor default. Assets that are equity interests or that call for management discretion beyond servicing activities may not be suitable assets for a QSPE CDO (servicing activities per FASB No. 140 do not include the discretion to sell defaulted assets and also limit the servicer's discretion to work out defaulted assets). The common structural features of ramp-up and reinvestment periods also become more challenging. However, QSPEs do have distinct advantages, foremost being that no investor consolidates a QSPE, even one who retains all or a majority of the economic equity of the CDO.
Often seen in practice are QSPE vehicles used for CDOs backed by complex debt securities, such as below-investment grade structured finance product. In many of these deals participants may prefer a static pool because of the limited number of investors interested in the below investment grade bonds issued by the CDO and the relatively large amount of due diligence most investors feel is needed to perform to make their initial investment decision.
If an entity is not a QSPE for accounting purposes, it will be either a VIE or a VoIE. Based on the concepts of FASB Interpretation No. 46(R) "Consolidation of Variable Interest Entities," most CDO vehicles will be VIEs. As a consequence, identification of the accounting parent of these vehicles is based on determining which party, if any, bears most of the CDO vehicle's economic risk or most of its reward. By contrast, identification of a VoIE's parent is based on determining which party controls the entity based on voting rights. FASB developed the concept of VIEs to deal with consolidation challenges arising from the use of special-purpose entities.
Variable interest entities
VIEs are far more flexible vehicles than QSPEs. A VIE can freely trade its assets and its asset manager is afforded the discretion to manage the CDO's assets, limited only by the preferences negotiated with rating agencies, hedge counterparties and the vehicle's investors. VIEs also are not limited as to the types of assets they can hold. VIEs do present special issues, however, to investors who wish to invest heavily in the subordinated securities of a CDO and to transferors who sell assets to the vehicle.
Under FIN 46(R) a CDO vehicle is a VIE if: a) the issued equity at risk is insufficient to permit the vehicle to finance its activities without additional subordinated financial support provided by any parties or holders of equity at risk lack the typical characteristics of a controlling financial interest; or voting rights of the equity holders b) are not in proportion to their obligation to absorb expected losses or receive expected residual returns and c) substantially all of the vehicle's activities involve or are conducted on behalf of an investor with disproportionately few voting rights.
Characteristics of a controlling financial interest are not present if the equity holders, as a group, do not have the: a) direct or indirect ability, through voting or similar rights, to make decisions about the vehicle's activities that have a significant effect on the success of the vehicle; or b) obligation to absorb the expected losses; or c) right to receive the expected residual returns.
When parties other than the equity holders at risk possess voting or similar rights, the analysis should challenge whether the equity investors' remaining and exclusive decision-making rights will significantly affect the success of the entity, particularly the amount of expected losses the equity holders would absorb and the amount of expected residual returns they receive. If, through third party arrangements or by operation of the governing documents, the equity holders at risk have been guaranteed a return or their return has been restricted, the equity holders lack the characteristics of a controlling financial interest.
By their design, actively managed equity issued by CDOs would not normally possess characteristics of controlling financial interests because a) asset managers, rather than the equity holders as a whole, hold the important decision making rights which result in the success of the vehicles and b) the equity holders' ability to remove asset managers is typically restricted.
Expected losses and residual returns explained
FIN 46 (R) defines expected losses and expected residual returns as the expected negative and positive variability, respectively, in the fair value of a VIE's net assets exclusive of implicit or explicit variable interests (described below). These amounts are not synonymous with GAAP profit and loss. If there is a need to quantitatively determine these amounts, FIN 46 (R) illustrates the use of a scenario-weighted discounted cashflow technique. Expected losses and expected residual returns represent the results below or above, respectively, the probability weighted average mean. Put simply, they represent the variability around the expected outcome. For example, if an entity will be profitable under any outcome, it can still produce expected losses, which represent the negative variability around the mean expected outcome.
Variable interests in a VIE are contractual, ownership or other financial interests which change with changes in the fair value of the VIE's net assets, exclusive of such variable interests. Such interests are anticipated to absorb the expected losses or receive the expected returns of a VIE's net assets, or contracts. Examples of variable interests in a VIE are, fixed-rate and floating rate debt, equity, some decision maker fees and certain derivatives. Variable interests absorb the variability of the VIE.
A variable interest holder that absorbs the majority of the expected losses or expected returns is called the "primary beneficiary" and must consolidate the VIE. Decision maker fees paid to an asset manager are considered a variable interests when a) the fees received are not commensurate with the level of effort required to provide the services; b) all or a portion of decision making fees are subordinated; c) the asset manager holds interests in the VIE apart from the management contract that will absorb or receive more than a trivial amount of the expected losses or expected residual returns; or d) obstacles exist which limit the ability of other interest holders to remove the asset manager.
Due to their subordinated nature, decision maker fees can put an asset manager at risk of consolidating the CDO vehicle when such fees absorb a portion of the CDO vehicle's "expected loss" and "expected return." Additional investment in any other variable interests of the VIE must be scrutinized, together with the variability in fees, to determine whether the majority threshold is reached.
Voting interest entities
A CDO vehicle that is not accounted for as either a QSPE or a VIE is treated as a VoIE if the a) total equity at risk is sufficient for the entity to finance its activities without additional subordinated financial support; b) equity holders have all of the characteristics of a controlling financial interest; and c) voting rights of the equity holders are in proportion to their economic exposure. Under this outcome, consolidation analysis uses other sources of GAAP to determine the accounting parent. In these cases, the accounting parent is the party, if any, controlling the CDO.
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