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WEANING OFF GAIN ON SALE ACCOUNTING
By Martin Rosenblatt, Deloitte and Touche, USA
Gain-on-sale accounting is the requirement under FASB 125 to recognize upfront gains or losses on securitisation of financial assets. As the author discusses below, gain-on-sale has come under critique recently both due certain instances of sudden decline in profitability and, in some cases, failures, as also due to the element of subjectivity inherent in such estimation. Martin's article is immensely relevant for anyone concerned with accounting for securitisation transactions.
Several securitizers have recently announced that they will discontinue the use of "gain on sale" accounting. This has been in reaction to the:
- Unwanted volatility in earnings that goes hand in hand with the timing of securitization transactions
- Vocal criticism (from equity analysts, in particular) that characterizes this accounting as "front-ending" income
- Rating agencies adding the securitization back to the balance sheet when considering capital adequacy.
The following discussion covers some of the accounting issues that a company should consider before making a switch. The discussion is highly technical in places and is intended primarily for those who are intimately familiar with FAS 125 and certain other related accounting pronouncements.
1. The FASB and the SEC staffs (EITF D-69) have determined that gain (or loss) on sale accounting is not elective in a securitization that is accounted for as a sale. In other words, prepayment, loss or discount rate assumptions may not be tailored so as to force a zero gain.
2. In order to report zero up-front gain, the securitization must therefore be structured as a financing rather than a sale in virtually every case. However, one technical exception exists in the following structure and fact pattern:
Assume that the securitizer issues a limited guarantee as credit enhancement for some or all of the bonds. Paragraph 45 of FAS 125 indicates that, "if it is not practicable to estimate the fair value of a liability," then the unknown liability should be recorded as the greater of:
- the sum of the known assets less the fair value of the known liabilities-- that is, "plug' the amount that results in no gain or loss; (Paragraph 46 [Case No. 2] in FAS 125 illustrates that accounting.) or,
- the FAS 5 liability (which may be zero).
As a practical matter, little guidance exists as to when "it is not practicable to estimate the fair value of liabilities," and a frequent securitizer would resist having to disclose an inability to evaluate the creditworthiness of the pool. Moreover, FAS 125 does not give guidance on the subsequent accounting, leaving any number of unresolved questions. For example, is income not to be recognized at all until it becomes practicable to estimate the fair value of the liability? And is income then to be recognized in one lump sum?
If it is not practicable to estimate the fair value of an asset (such as a residual interest), FAS 125 calls for it to be recorded at no value. Adherence to this accounting will usually result in a loss on sale.
- In circumstances other than the above, then, debt-for-GAAP seems to be the only practical structure. Management usually has a strong objection to this financing treatment, due to the resulting ballooning of the balance sheet and the negative implications that this has on debt/equity ratios, return on assets, debt covenant compliance, etc. It should be borne in mind, however, that the balance sheet does not balloon any further if all cash securitization proceeds are used to repay on-balance-sheet warehouse funding or other debt. On the other hand, the typical pattern of a frequent securitizer today is to keep on-balance-sheet warehouse funding to a minimum as of quarterly balance sheet dates and sale accounting is the means used to shrink the balance sheet debt.
- Before issuing FAS 125, the FASB considered, but rejected, the UK approach of a "linked presentation" in which the pledged assets remain on the balance sheet but the non-recourse collateralized debt is reported as a deduction from the pledged assets rather than as a liability and no gain or loss is recognized. Perhaps, it is time to reconsider that approach.
- The most common way of achieving debt-for-GAAP is by means of a call option that is beyond a cleanup call. While no quantitative guidance exists on the maximum size of a cleanup call, 10% has always been the norm. FAS 125 provides for a not too user-friendly definition of a cleanup call as occurring "when the amount of outstanding assets falls to a level at which the cost of servicing those assets becomes burdensome." The FASB considered, but rejected the suggestion that a transaction with (for example) a 30% call should be accounted for as a 70% sale and a 30% financing.
- Investors sometimes object to buying or paying full value for a bond (particularly a fixed-rate bond) subject to a significant call provision. This could perhaps be mitigated by setting the exercise price for the call at a premium, which should not affect the financing vs. sale determination under FAS 125.
- Other terms or conditions that would cause a securitization to be accounted for as debt-for-GAAP include:
- A call of any size (even 1%) if the transferor is not also the servicer. (Oddly enough, this is what the FAS 125 Q&A Special Report says. This conclusion, however, is slated to be overturned in the planned FAS 125 Amendment).
- Use of a wholly-owned SPE as the issuer of secured debt, if the SPE has been granted certain powers to sell its assets or enter into derivative contracts that disqualify it from being a QSPE under EITF D-66. (Such grant would cause the SPE to be consolidated pursuant to EITF 96-20.) Nothing has to last forever. If you later decide to sell at least one-half of the residual (i.e. the SPE equity), you can deconsolidate at that time and recognize gain or loss.
- Some unusual structural nuance that precludes counsel from issuing a "would" opinion, allowing only a true-sale "should" opinion (not applicable to banks).
- Transferring non-financial assets to the issuing SPE in addition to financial assets.
- Imposing restrictions on the investors' right to pledge or exchange their securities.
6. Back to calls, then. The first decision that must be made is whether the call option is on the transferred assets or on the issued bonds. Either way, the SEC staff (EITF D-63) has said that the transfer has to be accounted for as a secured borrowing.
But perhaps there is a difference in the balance sheet classification of the assets and the subsequent income effects. Paragraph 10 of FAS 125 says: "Upon completion of any transfer of financial assets," [author's interpretation: whether or not it satisfies the conditions to be accounted for as a sale], "the transferor shall: (a) continue to carry in its statement of financial position any retained interest in the transferred assets, including, if applicable, servicing assets, beneficial interests in assets transferred to a qualifying special-purpose entity in a securitization, and retained undivided interests and (b) allocate the previous carrying amount between the assets sold, if any, and the retained interests, if any, based on their relative fair values at the date of transfer." The term "transfer" is defined in paragraph 243 to include "putting it into a securitization trust" or "posting it as collateral." Paragraph 12 goes on to say that "If a transfer of financial assets in exchange for cash...does not meet the criteria for a sale...,the transferor and transferee shall account for the transfer as a secured borrowing with pledge of collateral."
My interpretation of those three paragraphs leads me to the following conclusions:
· If (1) the call option enables the transferor to repurchase the transferred assets from the SPE when the balance of the transferred assets is reduced to some specified level, and (2) the SPE would in turn use the call option proceeds to pay off the bonds and remit the residual assets, then, the transferor would (i) allocate the carrying value of the transferred assets between loans and a servicing asset (if the servicing fee exceeds adequate compensation), based on relative fair value, and (ii) record the securitization proceeds as a secured borrowing or, perhaps, a series of secured borrowings, if tranched.
· If, on the other hand, the call option enables the transferor or the issuer to repurchase the remaining classes of bonds when their balance is reduced to some specified level, the transferor would first allocate the carrying value of the transferred assets between each of the beneficial interests in the transferred assets (i.e., the bonds and a servicing asset) and would record the securitization proceeds as a secured borrowing or, perhaps, a series of secured borrowings, if tranched. If the transferor exercises the call and then owns all of the beneficial interests (the bonds and the residual), it could, but would not be obligated to, liquidate the trust and access the assets. Alternatively, it could resell the bonds.
The above represents my current reading on this point. In candor, I am not sure that I am right.
8. The significance of the above decision lies in the accounting treatment afforded the pledged assets.
· If the pledged assets are treated as loans (their previous treatment), then they would likely be considered loans held for long-term investment and not loans held for sale. Thus there would be no FAS 65 LOCOM requirement, although valuation allowances for credit losses would be required and perhaps no requirement to allocate any basis to servicing rights.
· If the pledged assets are treated as securities, then FAS 115 applies, and a decision as to HTM, Trading, or AFS is required.
If the call option is at (for example) the 15% level, then the following question arises:
If the intent is to call when it becomes exercisable and to liquidate the trust and reclaim the transferred assets, is that a "desecuritization" at that point with no gain or loss recognition or would it be considered a "taint" of the HTM classification?
My own view is that it would not be considered a "taint." (EITF D-51 permits desecuritization without "tainting.") In fact, paragraph 11b. Of FAS 115 says that the holder of a held-to-maturity mortgage-backed security could sell that security without a taint when at least 85% of its principal balance at acquisition has been received.
However, even if it is permissible to classify the pledged securities as HTM, an IO class would likely still be disqualified. Obviously, the trading classification, although technically allowable, would not make sense.
· If classified as AFS, should the asset side be marked to market (affecting equity and comprehensive income) without marking the corresponding liability side?
· Would the risk-based capital requirement for banks be different if the assets were classified as securities rather than loans?
· Can the "low-level recourse" rule for banks be made to apply if the securitization is accounted for as a secured borrowing?
· Should there be some other balance sheet caption to distinguish these pledged assets from the investment portfolio - for instance, "Securitized assets subject to repurchase option" (see paragraph 15 of FAS 125)?
9. When allocating the previous carrying value to the beneficial interests based on their relative fair values, is the fair value of a bond class determined with or without the embedded option?
My view is that the fair value for this purpose should be calculated to maturity rather than to the call date. I base this on the fact that the transferor can call and then hold or resell the bond rather than retire it. If the fair values are determined with the embedded option, should there also be an asset set up for the call option? FAS 133 doesn't think so - a view with which I concur.
10. I have seen a securitization transaction in which the transferor retained a call option on certain classes, but not on other classes, and accounted for the transaction as part financing, part sale.
11. Even accounting for a securitization as a financing requires the use of many subjective judgments and estimates and could still cause volatility in earnings due to the usual factors of prepayments and credit losses. After all, the company still effectively owns a residual even though you can't find it on the balance sheet. It is the excess of the securitized assets over the associated debt. Different accounting treatments will apply from origination through securitization and continue through maturity. Some of these differences are listed below:
- In the financing scenario, the decision on what origination costs should be appropriately deferred under FAS 91 rather than expensed takes on added significance in the first year income statement since they will remain deferred (amortized over the life of the loan) rather than effectively reversed within a short time frame in a gain-on-sale calculation. The pace of amortization will be affected by prepayments and prepayment estimates, as well as credit losses and estimates. On the other hand, the amount of origination fees such as points and premiums paid to purchase loans take on less first year income statement significance since they will be spread over a long period of time rather than effectively recognized almost immediately in a gain on sale calculation.
- When loans are originated or acquired with the intent to securitize as a financing, then the loans will be classified as held for long-term investment and not subject to a FAS 65 LOCOM adjustment (e.g., from rising interest rates) during the accumulation period. Although the economic risks still exist, a company might want to reconsider its hedging policies during that period because the "income statement risk" of a LOCOM adjustment or a lower gain on sale (e.g., if spreads widen) are mitigated.
- If loans are securitized, and the securitizer retains all of the resulting securities and classifies them as debt securities held to maturity under FAS 115, the securitizer does not have to recognize a separate servicing asset. That is, the value can be embodied in the carrying value of the debt securities. If a servicing asset is created, it will be subject to LOCOM accounting.
- Underwriting fees and deal costs of issuance will be deferred and amortized over the life of the bonds, and the pace of amortization will be affected by prepayments.
- Provisions for credit losses will be made periodically under FAS 5, rather than initially estimating all credit losses over the entire life of the receivables transferred and providing for them in the gain on sale calculation.
- Original issue discount on bond classes will be amortized and the pace of amortization will be affected by prepayments. Also, in a deal with maturity tranching, especially in a steep yield curve, significant amounts of "phantom" GAAP income could result.
Assume, for instance, that four sequential pay tranches are issued at yields of 7%, 8%, 9%, and 10%, respectively backed by a pool of newly-originated 10% loans. An overall yield to maturity on the assets is calculated and used for FAS 91 purposes, but interest expense on the bonds is calculated based on the yield to maturity of each outstanding bond. The result is that the net interest margin reported in the earlier years will exceed the net interest margin reported in the later years. Observe that, in this example, there would be no income reported during the years that only the last class is outstanding. A more conservative answer, but perhaps not GAAP, would result if the four bond classes were treated as a single large bond class, with a single weighted average yield to maturity used to record the interest cost.
12. In REMIC deals, which by definition are a sale for tax purposes, taxes will still have to be paid on any up-front tax gain and a deferred tax asset will be created for taxable income recognized before book income. When a company is willing to account for its transactions as financings, it can take advantage of certain features of the FASIT legislation that would have been in conflict with sale accounting treatment. In particular, the liberal substitution and permitted withdrawals of assets when overcollateralized and the ability to liquidate a class of securities and to hedge certain risks can be used to give an issuer significantly more flexibility than REMIC structures. This does nothing, however, to mitigate the showstopper in FASITs - the upfront "toll charge" tax on an artificial gain.
13. In comparing pro forma projected results of weaning off of gain-on-sale accounting, don't forget the income from the accretion of yield (at the discount rate) on the residual interests retained.
14. The FASB has proposed extensive new disclosures relating to securitizations, including the number and volume of transactions, cash inflows (outflows) with the securitization trusts, disclosure of assumptions, and a stress test or sensitivity analysis for the value of the retained interests. These disclosures will not apply to securitizations accounted for as secured borrowings. Some companies provide supplemental information showing key financial statement components on a pro forma basis as if their off-balance sheet securitizations were on-balance sheet. The FASB considered, but rejected, this type of presentation being a required part of the new disclosures.
SUMMARY
The FASB continues to maintain that "gain [or loss] on sale" accounting is the appropriate (and conceptually consistent) treatment whenever a sale has occurred, and that FAS 125 contains appropriate guidance for determining whether a sale has occurred and for the recording of the retained interests. Yet the investor community is increasingly dissatisfied with this accounting. The introduction of some non-substantive difference in the securitization structure might cause you to account for it as a secured borrowing, and this approach (which entails greater financial statement transparency) could hardly be criticized -- unless, of course, the technique were used to avoid recognizing an up-front loss on sale.