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Derivatives

Consolidation Of Special Purpose Entities

As part of its focus on special purpose entities, the Financial Accounting Standards Board (FASB) has undertaken several projects which re-define which party, if any, must consolidate the assets and debt of SPEs with which it is involved. FIN 461, released in January, applies to all actively managed financing structures including many commercial paper conduits. Proposed changes to FAS 1402, would apply to "passive" financial asset securitizations, including many mortgage and asset-backed transactions structured as qualifying SPEs (QSPEs).  

Key Concepts Of FIN 46

Financial Interpretation Number 46 introduces a seemingly simple economic test which requires an assessment of whether any one party involved with an SPE has a majority of the expected gains or losses of the SPE. This concept has proven difficult to implement for the variety of structures subject to the new rule, and accountants continue to grapple with its application. Rather than attempt to explain all of the detailed requirements of FIN 46, we have summarized its key concepts in the accompanying consolidation decision tree.

The application of FIN 46 requires all SPEs to be designated either as a Voting Interest or a Variable Interest entity. For SPEs under the Voting Interests model, FIN 46 does not apply. In order to apply this exemption, the SPE must have issued equity with characteristics which satisfy all of the conditions outlined in the first column of the consolidation decision tree. Under the Voting Interests method, consolidation is required if an entity owns at least 50% of the voting equity issued by an SPE.

If the equity, if any, issued by an SPE does not meet all of these conditions FIN 46 would apply. Application of FIN 46 requires (1) an identification of all contractual arrangements that would be considered a variable interest, and (2) an analysis of the economics (expected gains and losses) allocated to each of the entities which are party to the variable interests. Depending on the specific scenario or structure, variable interests may include common and preferred equity, debt securities, asset management or other fees, guarantees, forward contracts and total-return swaps.

Under FIN 46, the allocation of the SPE's economics must be analyzed to identify whether there is a single entity, known as the Primary Beneficiary, that is required to consolidate the SPE. The Primary Beneficiary, if there is one, is the variable interest owner which owns greater than 50% of:

* the expected losses; or

* the expected gains; or

* both.

If one variable interest owner has greater than 50% of the expected gains and another variable interest owner has greater than 50% of the expected losses, then the owner of the losses is the Primary Beneficiary and must consolidate the SPE.

The definitions of expected losses and expected residual returns, which are critical to the accounting analysis, are by no means intuitive. Expected losses do not comprise only losses of principal, but the probability-weighted present value of scenarios which may result in a lower return than initially expected.

Expected gains comprise the probability-weighted present value of scenarios that may result in a higher return than initially expected plus the present value of all fees expected to be derived by the asset manager or providers of guarantees on substantially all of the VIE's assets. As a result, for structures where there is a decision maker or guarantor, expected gains computed using this logic may be significantly higher than expected losses.

Given the difficulties in applying FIN 46, the FASB has recently issued several interpretations which address the calculation of expected gains and losses. These developments require monitoring since they may result in changes to currently accepted practice.

 

The FAS 140 Amendment Project

Although QSPEs, with certain limited exceptions, are excluded from the scope of FIN 46, there are mounting concerns regarding the FASB's recently-issued exposure draft of a proposed amendment to FAS 140. What started out as an interpretive issue around QSPE funding decisions has morphed into a significantly more problematic development addressing potential restrictions on the provision of a variety of support arrangements.

The exposure draft highlights FASB's intention to restrict the asset transferor's involvement with the QSPE, including the ability to provide unfunded support to a QSPE. This restriction would include liquidity facilities, guarantees and certain derivatives since they embody a contingent obligation to make payments to the QSPE.

Failure of QSPE status under the proposed amendment would result in the SPE being assessed for consolidation under FIN 46. Absent restructuring, this would result in consolidation by the seller in many cases. As is the case with developments under FIN 46, proposed changes to FAS 140 require close scrutiny given their potential consolidation impact.

This week's Learning Curve was written by Martin Kelly, senior v.p, and Kristie Wong, v.p, in the client solutions group at Lehman Brothers in New York.

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