“Kill the Q,” was the Financial Accounting Standards Board’s response to a self-examination about how to prevent a future subprime mortgage crisis. During a two-day meeting held in London last week, FASB and the International Accounting Standards Board met to discuss, among other things, whether a failure to comply with accounting rules, or in the standards themselves, contributed to the mortgage meltdown.
One fix, emphasized by FASB chairman Robert Herz, is to eliminate qualified special purpose entities (QSPEs) — or “Qs” — from the accounting literature. Currently, FASB is working on an exposure draft to do just that, and is expected to release the proposal for public comment sometime in June. SPEs are the dummy securitization trusts set up to allow banks take assets off their balance sheets.
Further, Herz and IASB chairman David Tweedie said that both boards are considering what to do with a trio of accounting concepts tied to the mortgage crisis — consolidation of SPEs, derecognition of the vehicles, and measuring financial assets and liabilities at fair value. “If you manage to produce good consolidation standards, all the pressure will then be placed on derecognition, as people try to get [assets] out of subsidiaries and into special purpose vehicles, and simply pretend to sort them,” added Tweedie, describing how fixing just one of the three problems would not solve the quandry.
SPEs became the subject of intense regulatory scrutiny after investigations revealed that Enron CFO Andy Fastow used the vehicles to hide massive losses before the company’s demise in 2001. But preventing Fastow-style shell companies also threatened the existence of trusts supporting billions in securitization, potentially forcing banks to consolidate them on their own balance sheets. As a result, FASB issued stricter guidelines to make sure that the so-called QSPEs could not be used for nefarious purposes. To ‘qualify’ as an SPE that can stay off a bank’s books, U.S. accounting rules require that the activities of QSPE’s be strictly limited to passively receiving and disbursing securitized funds.
Fast forward to the beginning of the subprime crisis, when suddenly the requirement that QSPEs be “brain-dead” machines itself seemed nefarious. Because banks merely acted as servicers of the loans they had securitized, they resisted calls to work with borrowers or restructure loans for fear that doing so would violate the QSPE structure.
Politicians had no such qualms. Faced with the spectacle of massive home foreclosures in an election season, both parties in Congress and the Bush Administration pushed the Securities and Exchange Commission to sign off on a banking industry plan to allow banks to rework mortgage terms without having to bring the trust assets onto their balance sheets.
Despite pages of careful rationalization by the American Securitization Forum, many accounting observers say that the act of breaking into the structure and altering the cash flow arrangement should have negated the bank’s passive status. That, in turn, should have cost many banks their off-balance sheet treatment, forcing them to increase the amount of regulatory capital they keep on hand.
If nothing else, the free pass from the SEC proved that the Q structure could not stand the market pressure of the current credit crisis. “I think [QSPEs] were tolerable until recently,” opined Herz. Once subprime mortgages were put into QSPEs, they were, “and I’ll use the pejorative term, ticking time bombs,” said Herz. “And the bombs started to explode.” He continued: “The real problem, in hindsight, was that the assets were not Q-able,” stressed Herz, who said that the vehicles required “intensive restructuring” that went beyond what would have been allowable for a QSPE.
“They’ve been stretched, it didn’t work,” Herz said about the securitization vehicles. As a result, FASB is on a “rapid” schedule to amend FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, to eliminate the concept of the QSPE by the end of the year. Herz said that FASB is under direction from the SEC and the President’s working group on the credit crisis — which includes members of the SEC, the Treasury Department, the Federal Reserve Board, and others — to fast track the FAS 140 project, as well as amending FIN 46R, Consolidation of Variable Interest Entities to make off-balance sheet transactions more transparent.
In February, Senate Democrat Jack Reed, chairman of the Banking Subcommittee on Securities, Insurance, and Investments, sent a letter to Herz and IASB chairman David Tweedie, calling for the rule revision. At last week’s meeting, Tweedie noted that the IASB also was under pressure to deal with the same set of issues FASB is considering. Tweedie cited a report released earlier this month by Global Stability Forum , a trade group comprising G7 Finance Ministers, central banks, and national regulators, that expressed concern about consolidation and derecognition of SPEs, as well as fair value measurement of financial assets. “We’ve accelerated all these issues, and they are a very high priority for us now,” emphasized Tweedie.
“I think we need to deal with [the trio of concerns] promptly, but whether we can have a converged accounting solution for the derecognition standard and the consolidation standard in short order is questionable,” opined FASB member Leslie Seidman about the prospects of issuing global accounting standards on the topics. “But it does seem very feasible to have a converged disclosure package in short order . . . [one] that would provide consistent information about the fringe areas, those gray areas,” she added.
Herz said that he didn’t think there was a lack of disclosure requirements in U.S. generally accepted accounting principles or SEC regulations. In fact, he said the existing FIN 46R disclosure rules, such as those related to maximum exposure, descriptions about the nature of off-balance sheet activity, and the involvement of a company in the transaction, were adequate. Further, in December 2005, FASB reminded companies of the applicable disclosures that might come into play if they originated, invested in, or had any involvement in subprime loans, said Herz. “Yet until things went downhill, they didn’t always elicit the kind of disclosures that were intended. I think, at least anecdotally . . . some [subprime] risks seemed kind of remote [at the time],” posited Herz.
Herz reckons that FIN 46R’s risk/reward calculations — the calculations that determine who, if anyone, must consolidate an SPE on their balance sheet — were based on models that, although largely done in good faith, were not updated as market events changed. “The models work until they don’t work. That’s what happened here, the models didn’t work,” quipped Herz. “So we need to update the standard for things that are not based solely on modeling.” Herz would like to see more qualitative evaluation and a requirement that mandates that the evaluation be reconsidered or updated on a regular basis, so it’s not just “a static calculation that only gets looked at if the terms of the deal changes.” The exposure draft for FIN 46R is also due out by June.
In what could be considered his swan song, or at least the beginning of one, outgoing FASB member Donald Young got to the heart of the matter during the meeting. “I think there is no doubt that the issues stemming from the credit markets . . . emanate first from extremely lax and sometimes fraudulent lending practices, particularly . . . but not confined to the United States. Then they were compounded by these ‘ticking time bombs,’ putting [the mortgages] into very complex securitization arrangements . . . and resecuritizing them into [collateralized debt obligations],” asserted Young.
Young, a former director and technology analyst, is stepping down this summer when he completes his three-year term with FASB. He continued: “I think if we look at the history in this area, we are really suffering ourselves to repeat it with this whole approach that we have taken. The boards before us weren’t a bunch of dummies and they were trying to shut down the activities that really were misrepresenting the economics.”
Young likes the idea of eliminating QSPEs and other “judgment work” from the two standards. Rather than leaving it up to companies to decide whether to recognize SPEs or not, Young is in favor of FASB’s alternative “linked presentation” concept, or something like it, in which “we get out of making the judgment call of when [a securitization transaction] is a sale.”
Regarding recording assets and liabilities at fair value, Herz and Tweedie again agreed that rules like FASB’s FAS 157, Fair Value Measurement, was correct in how it pushed companies to disclose measurement information — despite complaints from corporations about the mandate being too onerous. Herz said he thinks it would be useful if companies included a bit more supplemental information in this area. For example, he encourages companies to discuss in their management’s discussion and analysis section of their annual report valuation ranges and the length of time they expect to hold on to a financial assets — and update the information every period.