Tuesday, October 21, 2008

Mark this to Market

Qualified Special Purpose Entities (QSPEs) have been a boon to the financial industry in the last decade. QSPEs allow the transfer of loans off a bank’s balance sheet and on to other investors through a complex securitization process. With the loans off the balance sheet and proceeds from the securitization process banks have been free to originate new loans - many more new sub-prime loans.

The QSPE will be changed forever, at least for the financial industry, if the Financial Accounting Standards Board (FASB) can muster enough support for three of its newest proposals relating to fair value accounting standards. FASB is the private sector entity charged with setting standards for financial accounting and reporting,

Last month FASB issued three papers called Exposure Drafts for public comment. More than any other time when the FASB asked for public input, the present round of comments could be pivotal in how present credit conditions are resolved for the better - or worse. As with nearly everything the Bean Counters in Norwalk, CT undertake, the effort is laced with obscure acronyms (FIN, FAS, FSP) and long, opaque sounding titles (Amendments to FASB Statement No. 46[R], Consolidation of Variable Interest Entities). It is worthwhile to look past the arcane language to what FASB is proposing.

In simple terms, the first proposal is aimed at changing a current standard called Financial Accounting Standard 140 (FAS 140) that describes how to apply fair value accounting to off-balance sheet investments like QSPEs. For all practical purposes the proposed amendment would eliminate such QSPEs and require banks to show the value of those investments at fair value on the bank’s balance sheet beginning in 2010. The second proposal simply follows along this logic, proposing to amend the corresponding standard FASB relating to when banks must consolidate Special Purpose Entities (SPEs) and Variable Interest Entities (VPEs). Remember those from the Enron days?

A footnote in Morgan Stanley’s (MS: NYSE) FY2007 annual report provides a clue as to just one investment bank’s use of SPEs and VPEs. During the last three fiscal years Morgan Stanley received proceeds from securitization transactions totaling $197 billion. Morgan Stanley reported $5.3 billion in retained interests in securitized financial assets at the end of November 2007. The rest of the securitized assets in the form of commercial and residential mortgages and corporate bonds were held off the balance sheet in VPEs, which totaled $37.7 billion at the end of November 2007. Multiple these figures by some factor for the total picture of financial assets sitting on the sidelines of U.S. banks' balance sheets.

Are you ready to see the rest of the sub-prime loan debacle come onto bank balance sheets? Will the taxpayer need to pony up capital to help banks meet reserve requirements? Could greater transparency and accountability help prevent another round of excessive leverage? The public, that means you and me - can submit comments to the FASB up to November 15, 2008.

The FASB staff has been working on the matter for the last several years - since 2003. The FASB staff issued a request for information from the public (meaning other accountants) in April 2004. The responses were prescient. Look at the July 31, 2003, response from Jonathan Boyle from Fannie Mae (FNM: NYSE), who objected to the line of thinking now driving the recent proposed amendments to FAS 140. The comment letter from the senior accounting policy officer from Lehman Brothers (LEHMQ: PK), Kristine Smith, echoed Boyles objections to the proposed amendments.

If you can stomach accounting minutia, the long list of comment letters provides an excellent study on the practical side of accounting for the various toxic derivatives that are now clogging our credit markets.

For the particularly detail oriented, the three proposed statements are as follows:
First Proposal) Accounting for Transfers of Financial Assets – an amendment of FASB Statement No. 140
Second Proposal) Amendments to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities
Third Proposal) Proposed FASB Staff Position FAS 140-e and FIN 46 (R)-e – Disclosures about Transfers of Financial Assets and Interests in Variable Interest Entities

Neither the author of the Small Cap Copy web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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