Securitization Accounting Rules Changing, But Interagency Action Necessary

Accountants are changing the rules governing most of the shadow banking system and almost no one is noticing.

About 10 days ago, the Financial Accounting Standards Board confirmed that by year end “securitization accounting” will be different and the changes are likely to have a bigger effect on financial institutions than mark to market accounting. The new accounting rules will make it much harder for financial institutions to count securitizations as “off balance sheet” transactions and will reconsolidate, i.e., put onto the balance sheet, a large number of transactions that are currently accounted for as off balance sheet.

When financial institutions securitize assets and elect off balance sheet accounting treatment they are pretending that neither their securitized assets nor their related secured debt exists. Like a deadbeat dad denying paternity, securitization accounting is designed to avoid admitting responsibility by securitization sponsors.

Most securitizations are a form of secured borrowing executed by banks and other financial institutions. However, “form over substance” securitization accounting encourages securitization sponsors to act as if secured borrowings are really asset sales and thereby decrease the reporting of both their asset size as well as their debt.

When institutions use off balance sheet accounting for secured debt transactions, financial ratios are distorted and transparency is destroyed. No one can tell if securitizing institutions are well capitalized or not and whether their operating performance is consistent given the scope of their operations.

As a result of securitization, accounting financial institutions like Bear Stearns, Lehman Brothers, Citigroup and Merrill Lynch appeared much less leveraged, and much more profitable, than they really were. The “granddaddy” of securitization shops, Citigroup, at one time had more than $1 trillion of assets that it reported as “off balance sheet”. Citigroup pretended that the $1 trillion of off balance sheet assets were orphans; they just appeared one day on Citigroup’s doorstep. Simple financial measures such as net interest spread and asset quality and profitability ratios were vastly distorted by Citigroup’s orphans.

The securitization accounting rules also facilitated the “originate for sale” shadow banking system that lead to sub-prime and other consumer and commercial lending abuses.

The new securitization accounting rules are supposed to enhance transparency and make it much tougher for financial institutions to pretend that they don’t own their assets. But, no one is really sure how the changes will play out in the real world marketplace. The new rules may enhance transparency. On the other hand, mechanical application of new and complicated rules may confuse already incomprehensible reporting. Retro-active application of the rules may highlight how dangerously undercapitalized some financial institutions remain and may spark a new round of loss of confidence. Simplifying the rules may help restart the securitization marketplace and help the economy, but then again they may be another nail in the capital markets coffin.

I don’t know what this all means because I never understood the old rules and don’t know what the new rules will do to financial reporting. There is a Wall Street sub-culture that holds itself out to be “securitization accounting” experts. Personally, I never bought the “snake oil” that these guys were selling. I don’t think that the so called experts have a clue what is going to happen when the new rules are enacted and if they don’t know the media certainly has no clue which is why there hasn’t been much reporting of this accounting change.

It’s a good idea to fix securitization accounting rules and I support the effort; just not the way that reform is playing itself out. In fact on December 4, 2008, I wrote a letter to then President Elect Obama suggesting that reforming securitization accounting needs to be a cornerstone of financial institutions reform. The following is from my December 4^th letter:

If accounting rules matter, bad regulatory accounting rules matter even more. About 20 years ago bad regulatory accounting rules were enacted that apply to all banks and have the unintended side effect of encouraging the worst excesses of the securitization market. These rules reward banks that use the OPM model (i.e., “other people’s money”) to finance assets and penalizes banks that want to create well capitalized investment structures. These bank regulatory rules virtually mandate the “originate and sell” model of finance and need to be fixed immediately. Generally accepted accounting practices have run amok trying to work around the bad bank regulatory rules. The accounting industry is about to “reform” the rules relating to securitization accounting in FAS rule 140 but the new rules continue to make a mess of things. An interagency initiative is needed to fix this mess. And, interagency cooperation will only happen with Presidential leadership.

The problem with the current securitization accounting reform initiative is that it isn’t interagency reform but rather unilateral work of the Financial Accounting Standards Board, which has at best mixed motivations. Until securitization reform is a joint effort of all constituencies that are affected, it won’t work.

The U.S. needs a joint task force to address this issue including the SEC, OCC, FDIC, Federal Reserve and state insurance commissioners. Regulatory and statutory accounting rules must be conformed to financial accounting and disclosure. Securitization reform is needed, but ad hoc and piecemeal reform is probably worse than no reform and what we are getting is ad hoc reform.

Comments

[dertre:]

nice thing this securitization accounting but i guess the capitalization ratios won't be in % but in bps...

May 28 09:55 AM

[levin70:]

"I don’t know what this all means because I never understood the old rules and don’t know what the new rules will do to financial reporting."

Mark - its nice you own up to knowing nothing about the subject. However, given that fact, I find your desire to write the President about your ideas on how to fix a problem about a subject you know nothing about, pure hubris. Btw, the SEC, one of the "intergovenmental" agencies you want in the decision making process, is actually required to sign off on the new standard, as the SEC oversees all FASB pronouncements as they relates to US reporting companies.

Please try harder

May 28 12:30 PM

[Mark Sunshine:]

levin70

I appreciate your comments. Perhaps I should have been a little clearer. I taught accounting at the college level and spent 25+ years (starting in the early 1980's) acting as a securitization lawyer, banker and issuer. I won two IDD Deal of the Year Awards for innovative securitizations and have literally executed thousands of these transactions. I have testified in well known trials on substantive consolidation matters (as an expert). The company that I am currently the President of is a frequent issuer of securitizations (even during 2008 and 2009).

I am as good an expert as they come on securitization and if I have a tough time understanding securitization accounting rules the average investor (who doesn't have my training and experience) doesn't stand a chance. I may not be the smartest guy or the best accountant but my level of training can't be the standard to understand the accounting on trillions of dollars of financings and their impact on issuers.

If you were to accuse me of hubris it would be for thinking that if I can't easily figure something like out FAS 140 and FIN 46 it is too complicated for the average investor.

I believe that the majority of CFO's, CEO's and CPA's that rely upon FAS 140 and FIN 46 don't have a clue what the rules say or how to correctly apply them. I have found that when I question the application of those accounting rules I most often get fuzzy and inconsistent answers that indicate that management and the auditors don't understand it any better than I do.

The reason that I don't understand the rules is that they are incomprehensible and inconsistently applied. They were a response to the Enron (and other) problems and weren't well thought out. I assume that is the same reason others don't understand.

And, because the rules of the last 5 or 6 years were overly complicated and inconsistently applied, transparency hasn't been achieved.

Also, I know that the SEC has the power to sign off on public company financial accounting standards (I am a securities lawyer after all). However, it has been many years since the SEC has exerted that authority in any meaningful way. And, while the SEC has technical authority to change FASB pronouncements, their authority doens't extend to regulatory accounting principals (those are the rules that apply to banks and other depositories for figuring out whether or not they meet capital adequacy standards) or statutory accounting principals (those are the similar rules that apply to insurance companies). Without conforming changes to those regulatory and statutory rules havoc may ensue among regulated institutions. Also, it would be nice if the SEC used its authority to reign in FASB so that the amendments to FAS 140 and FIN 46 make sense.

I realize it is a little unusual for someone to actually admit that they have trouble understanding something like FAS 140 or FIN 46. After all, by making that admission I have opened myself up to ridicule. But I feel comfortable that my level of expertise and record of accomplishment is extensive enough that it will stand up to examination and most readers will hopefully realize that my statements are not frivolous. However, I accept that there are some readers who will reject what I have written and accuse me of incompetence.

Levin70, thanks for reading and I hope you reconsider your position.



On May 28 12:30 PM levin70 wrote:

> "I don’t know what this all means because I never understood the
> old rules and don’t know what the new rules will do to financial
> reporting."
>
> Mark - its nice you own up to knowing nothing about the subject.
> However, given that fact, I find your desire to write the President
> about your ideas on how to fix a problem about a subject you know
> nothing about, pure hubris. Btw, the SEC, one of the "intergovenmental"
> agencies you want in the decision making process, is actually required
> to sign off on the new standard, as the SEC oversees all FASB pronouncements
> as they relates to US reporting companies.
>
> Please try harder

May 28 04:45 PM

[Ishortyou:]

Securitizaton was created with the aim to mitigate risk, is essentially a wrapped up bond back up by assets of any sorts, most of them were mortgages. When Lehman fell the honor of contracts on those bonds were triggered and everyone (banks, brokers, insurances, individuals, etc.) have to come up with the money at once meaning they even have to mass sell even the collaterals, that dried up the liquidity on the market and the credit crisis sky rocket and because our economy was based on DEBT, no credit no economy.

May 29 07:57 AM

[Gtarras:]

Mark
I believe there were two major currents that shaped the way banks account for SPs (structured products).

1. SPVs and off-balance sheet accounting you described
2. Basel 1 and 2 requirement for the SPs that were on-balance, but still required LESS reserving compared with similar rated corporate and other credit.

I believe the new FASB rules will kill #1, i.e. all all SPs will be on-balance now.

So far, I believe Bssel requirements have not been changed, but there was talk they might (and they should, since a AAA (AA, A) SP tranche has proved to be lower quality than a AAA (AA, A) corporate, while earlier the thought was because they are more diversified, they are safer)

Would be interesting to track that Basel reqs developments as well.

May 29 02:44 PM

[Gtarras:]

also, to add to the earlier comment. IMO, the shadow banking system is single most important subject that needs to be tackled today, since it accounts for more than 50% of all money flows in the system. Accounting is one critical part of it, and I agree with you, deserves more attention it is getting. (structured products are the major driver of the shadow system)...

May 29 02:47 PM

[Mark Sunshine:]

Gtarras,

Thanks for your comments. I think you are "right on the money".

I am not totally current in the Basel rules as they apply to this area. They are very technical and very detailed. But my impression is that they fostered the orphan subs of the european ABSCP operations.

Do you agree?

May 31 09:58 AM