A number of significant developments in securitization accounting developed during the last few weeks of December, setting the stage for this year's trials and tribulations.
First and foremost, the Financial Accounting Standards Board (FASB) released what's being called FIN 46-R, or the December 2003 revision to Financial Interpretation No. 46. FIN 46-R was released on Christmas Eve. As such, there's yet to be a decent (or visible) stream of commentary from the accounting firms and banks that typically revised guidelines.
Of note, FASB opted to include Appendix B: five or so pages of examples of interests in an SPE and specifically, in cases such as decision maker fees, when these interests are considered variable interests. These include derivatives instruments, operating leases, forward contracts, guarantees and more.
As anticipated from early December deliberations, FASB has thrown a bone to the CDO industry by excluding the gross (or fair) value of decision maker fees from the expected residual return and expected loss analysis. This prior bias could have caused a significant number of CDO managers to be deemed the primary beneficiary in FASB's calculus, even if they held limited or no equity investment in the vehicle. Instead, FASB has affirmed in FIN 46-R that only the variability in decision maker fees will be included in the calculations.
Furthermore, if a manager can demonstrate that it is more in line with a service provider or employee of the CDO, it may be possible to have the fees eliminated as a variable interest. One requirement is that the collateral manager have no equity interest whatsoever in the deal, generally an uncommon situation as investors would rather the collateral managers have their interests aligned with performance.
However, as discussed originally in FSP FIN 46-c, there is threshold for kick-out rights - that threshold described as "substantive" - that can eliminate decision maker fees from the ERR/EL analysis; this arguably could better align interests, in the same way a board of directors in a corporation can vote out its senior management should they deem the managers as underperforming.
Regardless, most industry sources believe the changes in the treatment of decision maker fees - at the very least by eliminating their inclusion at fair value - is a positive for CDOs, and could change the result of the primary beneficiary analysis for many CDOs,
"I would expect that FASB decided to change this because it's a more evenhanded way to deal with it," said Jason Kravitt, of Mayer Brown Rowe & Maw. "First, it helps CDO managers, but at the same time it makes the modeling of expected losses for ABCP conduits somewhat more complicated," he said.
The idea here, according to one accountant, is that certain banks may have structured their expected loss tranches under the previous guidelines for determining decision maker fees and their part in the expected loss.
"FIN 46-R is still very vague and ambiguous in its new Appendix B on measuring the variability in variable interests, and specifically says that fees paid to decision makers are variable interests," the accountant said. "So, if a bank that was going the expected loss tranche route was not looking at it that way in the past, they would have to recalculate."
At this point, however, it is not clear whether this will be a significant issue for banks, industry sources said.
According to Kravitt, the market will see continued conduit restructuring during the first quarter of this year. After that, "things will move ahead full speed."
The issuance of FIN 46-R was decided by a five to two vote during a Dec. 17, 2003 Board meeting. The two dissenters were George Batavick and Leslie Seidman. In the exposure draft of the modification to FIN 46, three board members proposed a broad based implementation deferral until, at least, all FASB Staff Positions related to the new guidelines had been resolved. Sources said that FASB was under significant pressure from the Securities and Exchange Commission to have its modified version of FIN 46 out by the end of 2003.
As for implementation, most companies must apply the provisions of either FIN 46 or FIN 46-R for the reporting period that ended after Dec. 15, 2003 to all variable interest entities that would have been defined as SPEs under previous FASB literature. Companies can choose to implement under the earlier FIN 46, but must move to FIN 46-R by the end of the first quarter.
Companies that have already implemented FIN 46, and have to make changes in adherence to FIN 46-R, will be encouraged but not required to restate previous statements.
As for the amendment to FAS 140, last month FASB decided to push the project into 2004, and release an exposure draft sometime this quarter. If this agenda is adhered to, FAS 140 changes should be effective by Oct. 1, 2004 according to comments from Ernst & Young.