Most collateral managers of collateralized debt obligations will be able to avoid consolidating special purpose entities onto their balance sheets under new rules that will be proposed soon by the Financial Accounting Standards Board, legal and accounting experts with knowledge of the rules say. Treating SPEs as separate accounting entities is one of the major benefits of securitization and is seen as imperative to sustaining a healthy CDO pipeline. Previously, it was thought that most participants in a CDO would be forced to consolidate SPEs onto their balance sheets. "It looks like it's going to be okay for the CDO market," says Dan Castro, head of structured finance research at Merrill Lynch. He adds that, "Some of the provisions that might require some work will be minor and people will be able to work around them."
FASB met last week--the last step before a near-final draft of new rules on consolidation of SPEs. The proposed changes will be subject to a short comment period before the final ruling is published Dec. 31. The new rules will be in effect for new transactions immediately after the final draft and after June 15 for all other outstanding CDOs. (For a chronological recap of the FASB consolidation project see CDO supplement.)
Despite the positive implications coming out of last week's meeting, some market participants say there are still some gray areas concerning which entities will be able to enjoy the benefits of keeping SPEs off their balance sheets. Jim Mountain, a partner at Deloitte & Touche, says FASB has set up an intricate series of three tests. Any party that meets two out of three tests would be forced to consolidate. The first test for consolidation is whether a party is a "decision-maker" in the CDO, meaning whether it can "purchase or sell assets." The second is whether the party "absorbs" the majority of "risks" or expected losses. The third one is whether the entity can gain the majority of the rewards or residual benefits.
The problem, says Mountain, is that FASB has not been "clear" in its new "rewards" and "decision-making" concepts. One question remaining is whether a manager can be considered a "decision-maker" when he can only buy assets that meet certain rating criteria. "It shall be an interesting debate," he says, adding, "I'm hoping we'll be able to work through this without killing the market." A collateral manager says that European banks that invest in large equity pieces of CDOs are particularly worried. "The last thing they need is for this thing to be on their balance sheet," he said.
A sure positive development for CDO participants, although limited in scope, says Mountain, is FASB's decision to exempt from consolidation static pool CDOs in that those are non-actively managed deals. "One possible market impact is that people may try to structure new CDOs as static pools in order to avoid consolidation," he predicts.