December 16, 2009

All Banks Advised to Review FAS 166/167 Issues
Hidden in all the FAS 166/167 hoopla over the consolidation required for many assets sold into securitization structures is the fact that FAS 166 (Codification Topic 860) and 167 (Topic 810) will likely affect all banks, no matter the size and no matter the level of securitization activity.  In addition to the “well-known” issues, Accounting Briefs recommends that bankers review these issues with their accountants and auditors:

Loan participations (FAS 166):  Loan participations that currently exist are grandfathered in, so FAS 166 will not affect them.  However, banks should ensure that loan participation agreements entered into after 12/31/09 comply with FAS 166 in order to attain “sale accounting”, which allows banks to take the sold portion off their books.  Under FAS 166, any time part of a financial instrument is transferred (for example, in a loan participation), in addition to the standard provisions required to attain sale accounting, the part that is transferred must qualify as a “participating interest” in order for the transaction to be recorded as a sale (if the transaction fails sale accounting, you will leave the full loan on the books and record any cash received as a secured borrowing).  To qualify as a participating interest, all parts that are sold must generally be pro rata in ownership (for both the principal and the interest) and equal in priority of cash flows.  In other words, no LIFO or FIFO loans, no subordination, and no interest-only strips.  In addition, these interests may not be sold with recourse. 

When referring to the cash flows, FASB allows that reasonable servicing fees, origination fees, and syndication fees to generally be excluded from the pro rata/priority consideration.  So, the participating interest is determined after those amounts are taken out. 

We recommend that you discuss these with your business and lending personnel, as well as your accountants.  The new rules may require you to change the language of your future participation agreements in order to achieve sale accounting.

SBA and other popular loan programs (FAS 166):  Banks often participate in various loan programs with the Small Business Administration or Government Sponsored Entities (GSEs).  Depending on the program, sales treatment may not be possible. 

SBA Loans:  In certain programs, banks sell-off guaranteed portions of these loans and retain non-guaranteed portions. In many of these transactions, there is also limited recourse that is provided.  Under FAS 166, because there is an assumption of priority (due to the SBA guarantee) and because of the recourse provision, sales treatment may not be possible or may be delayed until the recourse or guarantee period is over.  This issue should be discussed not only with your accountants, but also the SBA representatives for your bank.

Lender Swaps with GSEs:  Many institutions sell loans to a GSE in return for a guaranteed security that is backed by the loans sold by the institution.  The guarantee provided by the GSE covers all or a portion of the credit risk.  This transaction was often treated as a “guaranteed mortgage securitization”, which had a specific exemption within FAS 140, automatically qualifying it for sales treatment.  This exemption has been discontinued and, as a result, no sale may be recorded.  This is NOT applicable to those banks that sell their loans for cash, but only for those transactions where the loans are swapped for the security.  Affected institutions will no longer be recording gains on sales or recording mortgage servicing rights, since sales treatment is no longer applicable.

Troubled Debt Restructurings (TDRs under FAS 167):  Many times, entities are formed for specific purposes, such as to borrow money in order to develop commercial real estate (CRE).  When the original loan is made, the entity may or may not be considered a Variable Interest Entity (VIE).  For an entity that is not originally considered a VIE, if the entity subsequently undergoes a TDR, FIN 46R currently exempts events related to a TDR from the requirement to reconsider whether that entity should then be considered a VIE.  However, that exemption is now eliminated.  Such an entity must now be evaluated to determine whether it is a VIE and, if so, whether it must be consolidated.  For example, due to the terms of a TDR, the holders of the equity interests of the borrowing entity may lose the power to control the entity’s economic activities.  In these cases, the bank will need to determine whether it must consolidate the assets and liabilities of the entity.

In most instances, no consolidation will be necessary.  However, disclosure may be necessary and internal control processes must be implemented to analyze such situations.  The disclosure requirements in FAS 167 are extensive and we recommend that those who are involved with TDRs on CRE properties discuss this issue with their accountants.

Remember:  FAS 167 is effective for any existing VIE as of January 1, 2010.  The effective date for FAS 166 is any transaction occurring on January 1, 2010 and beyond.  FAS 166 is applied prospectively, with past agreements grandfathered under the old guidance.