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In a strongly worded January 2003 report, the US Senate Permanent Subcommittee on Investigations stated that, by the end of this year, the SEC and US bank regulators should take action to preclude abusive structured finance transactions. The report applauds the use of structured finance to lower funding costs and diversify risk (true asset securitizations) but virtually demands the termination of false liability securitizations. False securitizations attenuate risk and hide assets and liabilities from investor and regulatory scrutiny.

The report traces a pattern of off-balance sheet transactions with risk retention that was similar to the on-balance sheet speculation during the 1980s (also facilitated by loose accounting rules), which contributed to the US Savings and Loan crisis. The Senate, Financial Accounting Standards Board (FASB), SEC and others have, it appears, forced changes in time to prevent an off-balance sheet recurrence of that earlier debacle.

Much is expected to happen during 2003. The first step was FIN 46, FASB's January17 2003 interpretation regarding consolidation of variable interest entities (VIEs). Next, there will be a FASB Staff Interpretation on issues relating to FASB Statement 140 (SFAS 140). Whatever is left to resolve is then likely to be the subject of SEC and bank regulatory policies to be reported to the Subcommittee by June and implemented by year-end.

Sales of financial assets with continuing involvement to lower funding cost will survive. Financial asset sale transactions under SFAS 140 are fully consistent with the goals outlined in the report. However, practices under SFAS 140 may change.

Three steps to preserve financial asset sales with residual recourse

As with sales of automobiles or televisions, financial asset sellers need to support the quality of assets sold (by subordinate recourse or other enhancements) in order to induce buyers to pay a fair price for the assets. To achieve that goal, paragraphs 9, 27, 35 and 46 of SFAS 140, and FASB Technical Bulletin 01-1 (interpreting paragraph 9a of SFAS 140), appear to mandate transfers in three or more steps to qualify for sale treatment.

The first step is a non-recourse "true sale or contribution" to a selling entity's wholly owned bankruptcy remote subsidiary (BRSPE). This isolates assets in the BRSPE. Once that step is completed, one or more BRSPEs can hold various residual rights and recourse (and rights to recover assets in a bankruptcy of non-consolidated transferees) under a clause in the last sentence of paragraph 27 of SFAS 140.

The second significant step is a limited recourse "debt-like" transfer to a "qualifying SPE" (QSPE). The obligation to protect interests retained by the BRSPE will generally cause a transfer to a non-QSPE to fail paragraph 9b of SFAS 140 (retained rights cause the transferee to be "constrained" from selling or pledging assets like an "ordinary transferee," as described in paragraph 176 of SFAS 140). Though a QSPE may be affiliated with the transferor, its retention of rights is also acceptable under paragraphs 9 and 27, because paragraph 46 of SFAS 140 precludes consolidation of a QSPE with a transferor or its affiliates.

The third step is sale of beneficial interests (BIs) in the QSPE to parties unrelated to the transferor.

If the initial BRSPE is also a QSPE, steps one and two can be combined, but restraints on asset re-sales imposed on QSPEs might then make it difficult for a transferor to dispose of residual interests. In general therefore, the BRSPE and QSPE are separate entities. Thus, a three-step sale is used to provide transferors maximum flexibility, and the ability to assure investors in the QSPE the quality of assets sold.

Transactions that meet the standards of SFAS 140 are generally unaffected by FIN 46. Under FIN 46, transferors to QSPEs remain exempt from consolidation. In addition, FIN 46 has an exception from VIE rules for non-transferors with interests in QSPEs, unless they have power to terminate or disqualify the QSPE.

Problems for commercial paper issuance

A clearly beneficial funding cost advantage of securitization arises when transferors and others can take advantage of normal (upwardly sloping) yield curves, by funding longer-term assets with short-term beneficial interests (BIs) issued by QSPEs. The most important type of short-term BI that achieves this benefit is fixed-maturity commercial paper (CP).

In general, creditworthy entities must be willing to acquire and hold contingent BIs of a QSPE or VIE (BIs that pay down as the assets liquidate), in order to fund a stand-alone QSPE or VIE issuing commercial paper. Standby BIHs are necessary so holders of commercial paper can avoid risk that the paper cannot be "rolled" (to pay maturing paper by the sale of new paper) when CP investors would otherwise sense that changing market conditions may impair a QSPE's or VIE's ability to fund. Without creditworthy parties willing to accept the mismatch risks that CP holders can face, it is likely that those risks would make CP of a QSPE impossible to sell.

VIEs can obtain liquidity from any source and will only consolidate if a liquidity provider holds a majority of the VIE's variable interests. What kinds of liquidity rights, however, can a QSPE own?

Paragraph 35 of SFAS 140 creates an exclusive list of assets that a QSPE can hold. In general, assets of a QSPE must be passive. However, under paragraph 35c (3), a QSPE can hold servicing guarantees and guarantees of the timeliness of payment on other financial assets, without reference to the passive test.

Guarantees of servicing and timeliness will not overcome the myriad of mismatch risks that can arise when issuing CP backed by longer-term assets. To resolve CP mismatch concerns, the BIs of a QSPE must be supported by a liquidity source (the standby BIHs mentioned above). Even when assets and servicing obligations fully perform, rate, timing and cash-flow mismatches can easily preclude the QSPE's ability to pay CP when and as due.

Because paragraph 35c (3) does not permit guarantees of BIs, liquidity for QSPEs must be held as a transferred financial asset (or a derivative financial instrument) that is passive in nature, under paragraph 35c (1) or (2) of SFAS 140.

A single sentence in paragraph 39 defines "passive" for these purposes:

"Investments are not passive if through them, either in themselves or in combination with other investments or rights, the SPE or any related entity able to exercise control or significant influence ...over the investee."

Thus, a financial asset is not passive when it is a liability of an affiliate of any party associated with the entity seeking to be a QSPE. Therefore, a QSPE cannot securitize liabilities of any associated enterprises. Where concurrence of obligation and entity exist, the asset of the entity is an obligation of a related party. As such, it is subject to an active relationship that is inconsistent with the role of a QSPE to hold passively financial assets for the benefit of investors in its BIs.

It is this characteristic of a QSPE that most clearly distinguishes these entities from VIEs and the Enron-like structures to which FIN 46 is directed.

A non-recourse obligation of a BRSPE, secured by third-party investees, with the BRSPE having only residual interests, is allowed under paragraph 35c of SFAS 140 because the investees in that instance are third parties. The BRSPE only holds BIs in the QSPE or its assets (residual rights that the BRSPE retains). It is only the existence, as an asset, of an obligation to make a future payment that is owed by an associated entity that disqualifies the QSPE.

Consequently, required rights to put assets or BIs to a creditworthy entity to support issuance of CP must, in the case of QSPEs, only be provided by entities that are not associated or affiliated with a transferor or any entity that is involved in the management of that entity. QSPEs are, in this sense, much more limited than VIEs.

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