FASB's Other Initiative

Jim Johnson of accounting firm Deloitte & Touche and Robert Scarborough of law firm Sidley & Austin explain how proposed new asset securitization rules could help structure new products and restructure old ones.

By Karen Spinner

FASB and Congress teaming up...to help derivatives dealers?!? Believe it or not, that could be the effect of FASB's latest derivatives accounting proposals-discussed on page TK-and some Congressional initiatives. Together, say these two experts, they could translate into new products benefiting both dealers and their corporate clients. Both proposals relate to financial asset securitization, a practice whose popularity with large corporations and commercial banks alike has outstripped related rules and standards. The proposed new accounting standard and legislation bring the guidelines more in line with reality by broadening the accounting and tax treatment of structuring securitized deals with derivatives components.

FASB's Improved Accounting Treatment For Securitized Transactions

The FASB exposure draft, when finalized, will replace the current SFAS 77 standard and will allow more securitized transactions to be treated as sales rather than financings. Sale accounting allows transactions to be recorded off balance sheet, making it more attractive to the buyers and sellers of securitized products. The draft standard, entitled "Accounting for Transfers and Servicing of Financial Assets and Extinguishing of Liabilities," was released by FASB in October 1995. The comment period closed in January, and a final standard is likely to be issued sometime this summer.

Because securitized transactions were in their infancy when SFAS 77 was initially introduced, no explicit distinction was made between the sale of the assets and any derivative products associated with the transaction. Jim Johnson, a partner at accounting firm Deloitte and Touche, explains that the exposure draft introduces what he terms a "financial components" approach to securitized transactions. This implies that whoever is selling the assets will be able to record their sale, and most derivatives embedded in the sale, separately; in the exposure draft, this approach will apply in some cases, though not in others.

This accounting separation is important because in most asset sales the seller typically offers the buyer a package deal, including the financial asset itself plus a derivative product. In many cases the terms of the derivative are embedded in the sales agreement. For example, let's say that a Japanese investor wants to purchase a U.S. company's dollar-denominated credit card receivables, but the investor wanted to mitigate some of the risks associated with yendollar exchange rate volatility. Under the exposure draft, the U.S. company would be able to make the sale while retaining the currency risk by either engaging in a straightforward currency swap or embedding such a swap in the terms of sale.

Under SFAS 77, this transaction would raise major accounting issues such as the seller's having to record the transaction as a borrowing. Says Johnson, "Relative to the old FAS standards, this new proposal expands the types of derivatives the seller may offer and broadens the definition of the financial instruments which can be included in the package."

Under SFAS 77, the seller can retain only a few explicitly defined risks and keep the benefits of sale accounting. However, under the proposal, the seller can keep any risks which fall within the general conditions for sale accounting, giving the seller many more options. It is this attribute of the exposure draft in particular that carries the potential for new product development, because in order to attract more buyers, sellers of securitized assets want to be able to offer custom-tailored and often lower-risk products.

Of course, the exposure draft is not a wholesale invitation to embed a hundred flavors of risk in asset sales agreements. Instead, it takes an evolutionary approach, enhancing flexibility in the following areas:

1) Credit risk. One common way for sellers to make their securitized assets more attractive to potential investors is to strip out the credit risk on the underlying receivables. Effectively, the seller writes a put option, allowing the buyer to sell receivables back to the seller in the case of default by one or more of the underlying borrowers. SFAS 77 states that to receive sale accounting treatment, the seller must be able to estimate its credit risk exposure. As Johnson interprets the exposure draft, it has no such limitations, although "the seller's inability to value credit risk will preclude the calculation of upfront gain on the sale of receivables."

2) Interest rate risk. One of the transactions specifically allowed under SFAS 77 is the sale of fixed rate receivables for floating rate payments and vice versa. The exposure draft calls this arrangement an interest rate swap, whether or not it is embedded in the sale document. The swap would be recorded at its fair value at the sale date. The difference between the exposure draft and SFAS 77 in this case is simply clearer language.

3) Currency risk. Under SFAS 77 a currency swap between the seller and buyer precludes sale accounting treatment, despite the economic similarity between currency and interest rate risk. The exposure draft eliminates this restriction, allowing currency swaps to be treated in the same way as interest rate swaps. This change could be very beneficial to dealers and their customers. In fact, the dollar­yen example above is representative of the sort of transaction that could, under the new standards, become much more feasible.

4) Unconditional put option writing. Under SFAS 77 put options written by the seller can only be used to protect the buyer against borrower default, to compensate the buyer in the case that the receivables fail to meet the criteria spelled out in the sale agreement, or to compensate the buyer in the case of borrower prepayment, which is a common event in the case of, say, securitized mortgages. Any put options that do not fall into these three categories would preclude sale accounting. Instead, the seller is obliged to treat the transaction as financing.

The exposure draft asks that sellers account for written put options (explicit or embedded) as separate financial components but, notes Johnson, "it does not conclude that unconditional put options held by the buyer automatically make the transaction a financing." The greater flexibility under the exposure draft opens the door to a variety of new structures. Johnson provides the following example. Consider investors with a one-year investment horizon. These investors normally would not buy securities structured on a pool of five-year, fixed rate home improvement loans because of the mismatched time horizon. If they could purchase a one-year put option on the uncollected balance of these underlying loans, the securities in question might look much more appealing.

5) Unconditional call option writing. Though the exposure draft offers a glimmer of flexibility, the nature of call options are such that few would benefit from sale accounting treatment under either standard. As in the case of unconditional put options, SFAS 77 states that if the buyer holds a call option to repurchase the receivables involved in a sale, then the transaction must be accounted for as a financing. The exposure draft, however, says that sellers can write call options on the assets sold, "so long as the assets under option are readily obtainable for payment." While this offers sellers a little more leeway, it's not much because most securitized assets, such as balances on credit cards issued by a particular bank and auto loans made by a particular company, are highly specialized and cannot be readily obtained in the general market.

6) Repo agreements. SFAS 77 says that if the seller agrees to repurchase the assets at a give date, as in a forward agreement, the sale will be recorded as a financing transaction. The exposure draft, on the other hand, allows sale treatment as long as the forward agreement is for more than 90 days after the date of sale and the assets are readily obtainable. Once again, the "readily obtainable" clause means that while flexibility has been slightly enhanced, many deals involving repurchasing will still receive financing treatment. However, it is important to keep in mind that the above-mentioned standard for repos is likely to change based on deliberations following the exposure draft; most repos will likely be treated as borrowings.

"The exposure draft is not revolutionary," says Johnson, but it does provide considerably more accounting flexibility for the sellers of securitized assets. For creative dealers this potential replacement for SFAS 77 should open a substantial window of opportunity.

FASIT-Congress's Innovative New Investment Vehicle

The Revenue Reconciliation Bill of 1995, which still remains in the Congressional legislative queue, proposes a new investment vehicle that could ease the tax restrictions on debt-and-derivative combination securities. Since it has different tax-trigger thresholds than the structures used today, the financial asset securitization investment trust (FASIT) will create opportunities for innovation by investment and commercial banks. For example, explains Robert Scarborough, a partner at the New York office of law firm Sidley & Austin, FASITs could be used to create multiple classes of debt backed by, say, a combination of mortgages and interest rate swaps. Such a structure today, notes Scarborough, would not be possible without incurring a prohibitive tax bill.

FASITs are similar in spirit to real estate mortgage conduits (REMICs), which were created in 1986. But FASITs are much broader in scope and able to hold a wide selection of debt instruments, such as credit-card receivables and car loans, as well as certain derivatives. Like REMICs, FASITs can take a number of forms; they can be trusts, corporations, partnerships or even a segregated pool of assets. According to the proposed legislation, a FASIT's assets must fall under one of the following categories: cash, cash equivalents, fixed or floating interest-bearing debt instruments, certain property acquired in connection with a default or an imminent default, certain contract rights that hedge the FASIT's obligations, or contract rights to acquire either debt instruments or hedges that would qualify as assets of a FASIT.

The contract rights described above might include a variety of derivatives, including interest rate and currency swaps, caps and floors. Scarborough says that a FASIT holding fixed rate mortgages could enter into a fixed-for-floating interest rate swap and issue floating rate debt to investors. Similarly, a FASIT holding yen-denominated receivables could enter into a yen­dollar swap and issue dollar-denominated debt.

The FASIT structure offers a flexible alternative to many traditional structures, including grantor trusts, owner trusts and partnerships, which are currently used in a variety of ways to offer debt securities backed by derivatives or derivatives blended with other assets.

1) Grantor trusts. Commonly used to combine debt instruments with derivatives, grantor trusts may be exempt from the entity level tax (the tax owed by a separately incorporated company such as a trust) if they meet the following requirements. The trust may not vary the investment of those holding certificates issued by the trust. The trust may issue only one class of ownership interests. In the few cases where multiple ownership classes are permitted, each ownership class must correspond with a separate asset held by the trust.

FASITs, on the other hand, do not have these limitations. Asset variation would be permitted, and thus debt instruments and derivatives could be added to the FASIT after its formation without triggering adverse tax effects. Also, FASITs could issue numerous classes of securities, and there is no requirement that these correspond directly with a particular class of asset held by the FASIT.

Furthermore, FASITs are permitted to issue debt-even high-yield debt which may under some guidelines receive equity treatment-whereas there is some uncertainty as to whether or not a grantor trust can issue debt and maintain its tax-exempt status. Indeed, this uncertainty is currently an issue for firms that are considering whether or not to issue hybrid debt, such as Merrill Lynch's trust-originated preferred securities (TOPRS) or Goldman Sachs' quarterly income debt securities (QUIDS).

2) Owner trusts. Because of the uncertainty regarding grantor trusts described above, many firms which want to issue debt-backed securities structure the issuing trusts such that they can qualify as partnerships. Owner trusts structured in this manner, says Scarborough, can issue debt backed by a combination of debt instruments and derivatives. However, these trusts still face a number of constraints which the FASITs would not. For example, the trust's debt must be considered pure debt under common law debt­equity tests. Scarborough explains that should debt turn out to be equity, investors in the securities issued by the trust could face adverse tax consequences. The debt could also trigger entity-level tax treatment.

An owner trust whose securities are backed by mortgages cannot issue different classes of debt with different maturities; if it does, once again, the entity-level tax will apply. And, finally, the owner trust risks incurring entity-level taxes as a publicly traded partnership, depending on how transfers of equity interest in the trust are handled.

3) Partnerships. Another option for firms looking to securitize debt is to create a partnership that issues only equity interests to investors. But, as touched on briefly above, the partnership approach is of limited use for a variety of reasons, the most important of which are the publicly traded partnership rules. And although publicly traded partnerships may escape having to pay an entity-level tax if 90 percent or more of its gross yearly income consists of qualifying income, there is no consensus as to what is qualifying income.

Thus, says Scarborough, the FASIT provisions included in the Revenue Reconciliation Bill of 1995 would, if enacted, "greatly ease the use of derivatives." And, coupled with FASB's proposed accounting changes, these new rules could usher in a new growth era in derivatives designed specifically for asset securitizations. Dealers-and their customers-should prepare.