Special Purpose Entities and Off-Balance Sheet Accounting:

The WSJ reports today that financial services industry groups are pressuring Congress and the administration to delay or weaken the effects of an accounting rule change slated for next year that would force banks and other financial services firms to keep, or take back, on their balance sheets assets shifted into special purpose entities (SPEs or SPVs):

[T]he group of financial organizations is trying to put the brakes on the off-balance-sheet accounting measure, which would force banks to bring hundreds of billions in assets back onto their balance sheets at the beginning of 2010, effectively forcing them to set aside more capital. Some accounting experts say they aren't surprised by the banking industry's latest effort. "Here we go again. They will get out their checkbooks and go to the Hill," says Lynn Turner, the Securities and Exchange Commission's former chief accountant.

The rule would apply to existing off-balance-sheet entities, known as qualifying special purpose entities, which were generally used by banks to package and sell off to investors loans they had made.

In general, I favor the rule change, as I also favor the earlier mark-to-market rule relaxation - although each with important reservations and caveats. The well-known accounting expert Robert Willens commented in the Journal article:

The rule "includes securitization vehicles that played a large role in the bubble and allowed banks to operate with low levels of capital even though they had exposure to these assets that weren't on the balance sheet," says accounting analyst Robert Willens.

I partly agree and partly disagree with that characterization, which explains my cautious, caveated view of the rule requiring that SPEs be consolidated. I don't think, on what I've seen so far at least, that it was securitization as such (including asset securitization that goes beyond simply the basic concept of pooling loans and selling interests in the pool, to include the much more legally specific concept of securitization involving a sale by the originator of the loans into a SPE legally insulated from the originator) that was most important in leveraging up the financial services industry and financial markets. More important than the bottom level securitizations, so far as I can currently tell, were the credit derivatives built on top of the securitizations. I might turn out to be wrong about that, but it's my current sense of the leverage (see this post on the excellent Accrued Interest blog for a sense of just how dicey these could be).

In looking to prevent a re-run of the crisis, I think I would start (on this particular regulatory bit of things) at the top of the leverage chain and ratchet down from there, rather than starting with securitizations as such and working my way up. There would still be good reasons to require consolidation of SPEs back onto originator balance sheets in some circumstances, I'm sure, but I think I'd start in (this area of) regulatory reform with the most (over)-leveraged parts. But I'm very, very interested in hearing views on this, as I could be persuaded otherwise.

Here is a test for consolidation: if the SPE were to fail, would the sponsor be forced (either contractually or as a practical business matter) to step in as a backstop for the SPE?

Of course, under the same test, much of the U.S. financial system should be consolidated with the U.S. government.
6.4.2009 3:56pm
Michael F. Martin (mail) (www):
A core problem is that the reporting rules do not scale well. It's fine to have an SPE when it's a small fraction of total liabilities. Not so much when it's 50% or more.

Everybody needs to lay their cards out face up before we start another round. There is a serious information problem (or knowledge problem a la Hayek) at the core of this crisis. The accountants be mangers complaining about the logistics need to stand down for the sake of everybody else in our society.

But once the cards are face up, I believe it will be clear that the whole system of reporting and auditing cannot keep up with the rapid changes now occurring within even smaller firms. We need to develop a set of auditng and reporting rules that will keep managers honest even when none of them individually has a complete understanding of the system in which their firm operates.

I think real-time reporting of journal entries to balance sheet accouts is one possibility. The big boys are already playing under that kind of scrutiny. Let's just level the field.
6.4.2009 4:00pm
martinned (mail) (www):

the whole system of reporting and auditing cannot keep up with the rapid changes now occurring within even smaller firms

So the US should move to a principle based system instead of a rule based one?
6.4.2009 4:12pm
rosetta's stones:

"...I think I'd start in (this area of) regulatory reform with the most (over)-leveraged parts."

I think the congresscritters will start on the area of regulatory reform that will maximize campaign contributions. Period.

Fine with all the technical analysis, KA, but until we can firmly parry this industry's constant attempts to raid the Treasury whenever things go sour, they will continue to do so, no matter our whack-a-mole attempts at regulation. They pay, and they always collect on that investment. We can't allow them to collect... it's that simple.

When you say "start at the top", I believe that's exactly what we should do... in order to give your statement validity... start at the top of the issue. Somebody has to say "no". In my experience, that answer always works wonders in the world of finance, and all decisions subordinate to that one become clear and defined, and much complexity is erased. That's far more powerful than regulation.
6.4.2009 4:24pm
Michael F. Martin (mail) (www):

Which is more scalable? That's the question. I don't know the answer.
6.4.2009 4:32pm
Houston Lawyer:
The regulators really need to back off and consider the consequences of the rules they write before they implement them.

Right now, I've got a firm commitment underwritten offering being held up at FINRA just because the reviewers there don't give a rats ass about doing their jobs. FINRA (the Financial Industry Regulatory Authority) was set up to replace the NASD. FINRA must approve the underwriters compensation disclosure in our base prospectus before we can file a prospectus supplement. The problem is that there is no underwriter compensation disclosure in the base prospectus, all of that information goes in the supplement. So, we've been waiting for more than three weeks for FINRA to do nothing.

From what we hear from our peers in the industry, this has become standard operating procedure at FINRA. If players in the financial industry get abused here, they will go elsewhere.
6.4.2009 4:37pm
DWAnderson (www):
What is the rationale for consolidating SPE's? I can think of only two: (i) because they are highly leveraged their value is quite volatile, and (ii) there is potentially significant recourse to the parent entity.

It seems to me that (i) is best dealt with by some sort of other disclosure rather than consolidating a bunch of debt for which there is no recourse to the parent.

Addressing (ii) is more difficult and goes generally to how contingent liabilities are accounted for under GAAP. Right now if there is very little liklihood a parent guaranty will be called on, it is not counted as a liability. That is probably inadequate as the economic value of the potential liability in greater than $0. But knowing how to value it is really hard to do systematically (there is no market price for the potential liability). As with (ii) perhaps the best that can be done is better disclosure of the existence of the potential recourse rather than trying to pin a number on it.
6.4.2009 4:46pm
A. Zarkov (mail):
The Federal Reserve stands accused of using off balance sheet accounting. Bloomberg News says the Fed has conducted $9 trillion in unreported transactions. The Fed IG when questioned by Congressman Grayson on this matter clammed up like a Mafioso. See her testimony (actually lack of) here. Like Grayson any sensible person should be shocked.

Shouldn't the government get its own house in order too? I realize that the Fed is mostly private, but it is at least quasi-governmental, and why should we let it get away with off balance sheet accounting. Why doesn't Congress demand an accounting-- after it created the Fed and it could do away it or at least reform it.
6.4.2009 5:14pm
byomtov (mail):
I think I would start (on this particular regulatory bit of things) at the top of the leverage chain and ratchet down from there, rather than starting with securitizations as such and working my way up.

This makes sense to me.

Is it not reasonable to think that the greater the leverage in the SPE the more likely the guaranty, explicit or implicit, will be called on?
6.4.2009 5:18pm
Crunchy Frog:

It seems to me that (i) is best dealt with by some sort of other disclosure rather than consolidating a bunch of debt for which there is no recourse to the parent.

That's the whole point - to stop the parent intstitutions from generating such worthless crap in the first place.
6.4.2009 5:20pm
Sebastian the Ibis (mail):
The Fundamental Problem with SPV's is that their value is derived entirely from their purported diversity. The risk of the assets is supposedly averaged and apportioned so that every investor supposedly knows what their buying into.

However, the SPV's are constructed of crap, not the statistical average the creator bases the valuations on. The Originator knows this, that's why they move them off of their balance sheet, the purchasers don't since "diversity" made valuing the individual assets impossible for anything less than a team of Nobel Laureates.

It all goes back to the most simple rule of negotiation: Don't sit down at the table unless you know who the sucker is and what the angle is, because if you don't it is you.

If the government really wanted to make the world safer for investors, they should enact standards relating to managers understandings of the underlying assets not on disclosure.
6.4.2009 5:45pm

So the US should move to a principle based system instead of a rule based one?

Isn't that going to happen to some extent under convergence with IFRS anyway?
6.4.2009 6:33pm
Christopher Cooke (mail):
I guess I am, by default, in favor of more disclosure, not less.

SPEs have been abused in the past --Enron--to mask big problems and to present a too rosy picture to investors.

Banks are now fighting any attempt to have them consolidate SPEs into their consolidated financial statements. Why? To mask big problems?

To me, the answer should not be "what about the impact on the banks," it should be one of accounting and legal theory. Some SPEs clearly strike me as legitimate and for these, the arguments in favor of not consolidating them are quite persuasive.

I think we need a reality-based test, as suggested by GD, and not let ourselves get worried by panic setting in if people know the truth. In fact, with the economy in the doldrums, it would be the perfect time to get all of the bad news out in the sunlight, so that we will have a meaningful recovery later.
6.4.2009 8:43pm
LibertyCowboy (www):
I'd like to point out that changing accounting rules in and of themselves won't make an entity more or less solvent. BoA will find a way to lose money under any concievable set of accounting rules or regulations.

I basically agreee with GD on the accounting itself, in that a bank must account for any asset's possible value which could be required to repay depositors.
6.4.2009 10:10pm
Fat Man (mail) (www):
More than really want to know about Securitization:

Securitization and Its Discontents: The Dynamics of Financial Product Development
Kenneth C. Kettering
New York Law School; University of Miami - School of Law
Cardozo Law Review, Vol. 29, p. 1553, 2008
NYLS Legal Studies Research Paper No. 07/08-7
6.4.2009 10:55pm

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