While the securitization accounting community sighed with relief at the revision to Financial Interpretation No. 46, plenty of gripes are still echoing through the market.
Last week, for example, researchers from Banc One Capital Markets estimated that FIN-46 “will have a lasting effect on the market, depriving it of $20 billion per year in new CDO issuance.”
Banc One’s CDO research head, Russell Hurst, believes that insurance companies and banks will pare down the use of cash CDOs for risk management, because of the potential balance-sheet impact. These companies may choose to use synthetic structures instead, “pending the outcome of current derivative accounting discussions here and abroad,” Hurst writes.
By contrast, comments from accounting firm Ernst & Young indicate a more optimistic view. Ernst has informally circulated a whitepaper detailing the changes to the treatment of decision maker fees, titled FASB Finally Responds to CDO Industry Concerns.
As a market consensus, FIN 46-R treats decision maker fees in a CDO more rationally than its predecessor (see ASR 1/6). At most, only the variability of a decision maker’s fee will be included in the expected loss/expected residual return analysis for determining the primary beneficiary in FIN 46-R. In the initial FIN 46, those fees were included at their fair market value, which created a bias toward the CDO collateral manager being deemed the primary beneficiary, even if that manager held no equity.
“I think under the old rules, there was some talk of reducing CDO fees [to avoid consolidation],” said Lisa Filomia-Aktas, partner and practice leader at Ernst & Young and author of the commentary. “They may not need to go down that route anymore, as there may not be the incentive to reduce the fees.”
FIN 46-R also outlines a stringent path to exclusion of the fees entirely, though that would require the manager to hold close to zero equity. For the exclusion to be considered, the service provider should not hold variable interests that “absorb/receive more than a trivial amount of the expected losses/expected residual returns,” according to Ernst, anticipating that the “trivial” threshold will be in the 2% to 3% range.
“As time goes by, people generally move toward one industry standard,” said Filomia-Aktas. Other criteria include fees that are commensurate with services provided, fees no lower in seniority than the operating expenses of the vehicle, and the existence of substantive kick-out rights.
According to Filomia-Aktas, prior to FIN 46-R, some structurers were heading down the voting interest entity (VoIE) route, where the CDO would be evaluated under a different set of accounting literature. The challenge with this method, ironically, was that in a typical CDO, the noteholders have certain voting rights that might have violated the criteria required for the equity holders to be determined the decision makers.
“The criteria for substantive kick-out rights are also being applied in determining whether the equity has the decision-making abilities,” Filomia-Aktas writes.
Other accounting firms, such as Deloitte & Touche, have also recently released commentary on FIN 46-R. Last week, Deloitte distributed an outline of FIN 46-R, which it dubs “a map redrawn.” Deloitte continues, “Even with a better map in hand, the journey promises to be arduous. But travelers should be better equipped to eventually reach their destinations.”
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