C'est La VIE: FIN 46.Financial Interpretation 46 (FIN fin, organ of locomotion characteristic of fish and consisting of thin tissue supported by cartilaginous or bony rays. In some fish, e.g., the eel, a single fin extends from the back, around the tail, and along the ventral surface. 46) and its subsequent revision in January of 2003 (FIN 46 R) has changed the rules for the consolidation of variable interest entities (VIEs). An asset-backed commercial paper conduit conduit /con·du·it/ (kon´doo-it) channel. ileal conduit the surgical anastomosis of the ureters to one end of a detached segment of ileum, the other end being used to form a stoma on the is a VIE and thus affected by this accounting interpretation. A Qualifying Special Purpose Entity (QSPE QSPE Qualifying Special Purpose Entity ) as defined by FAS 140 is exempt from the FIN 46 and need not be consolidated with another entity even though it satisfies the definition of a VIE. Securitization Securitization The process of creating a financial instrument by combining other financial assets and then marketing them to investors. Notes: Mortgage backed securities are a perfect example of securitization. May also be spelled as "securitisation. vehicles that art not QSPEs are constrained con·strain tr.v. con·strained, con·strain·ing, con·strains 1. To compel by physical, moral, or circumstantial force; oblige: felt constrained to object. See Synonyms at force. 2. by Fin 46 R. Sponsors of asset-backed commercial paper conduits art usually suppliers of credit enhancement Credit Enhancement A method whereby a company attempts to improve its debt or credit worthiness. Notes: Credit enhancements take many different forms. An example of a credit enhancement would be conversion rights added on to a debt instrument in order to lower the issuing and liquidity support to the conduits. Financial institutions that do not sponsor commercial paper conduits also supply credit and liquidity support to commercial paper conduits. General Electric Capital Corporation sponsors several commercial paper conduits and supplies financial support to these conduits. At year end 2002 GE Capital had approximately $16.9 billion in credit support outstanding to securitization vehicles and $10.3 billion in liquidity support that can be drawn within the year. By placing itself in the position of being the primary financier of the credit risk embedded Inserted into. See embedded system. in the pool of assets funded by the asset-backed commercial paper program in terms of value the sponsor takes the position of being the primary risk bearer One who is the holder or possessor of an instrument that is negotiable—for example, a check, a draft, or a note—and upon which a specific payee is not designated. and thus the "primary beneficiary beneficiary Person or entity (e.g., a charity or estate) that receives a benefit from something (e.g., a trust, life-insurance policy, or contract). A primary beneficiary receives proceeds from a trust or insurance policy before any other. ". "The primary beneficiary of a variable interest entity is the party that absorbs a majority of the entity's expected losses, receives a majority of its expected residual returns Residual Return Return independent of the benchmark. The residual return is the return relative to beta times the benchmark return. To be exact, an asset's residual return equals its excess return minus beta times the benchmark excess return. , or both, as a result of holding variable interests, which are the ownership, contractual, or other pecuniary Monetary; relating to money; financial; consisting of money or that which can be valued in money. pecuniary adj. relating to money, as in "pecuniary loss. interests in an entity that change with changes in the fair value of the entity's net assets Net assets The difference between total assets on the one hand and current liabilities and noncapitalized long-term liabilities on the other hand. net assets See owners' equity. excluding variable interests." (FIN 46 R) Even if each seller of assets to the program must fund the first 10% of credit losses the dispersion dispersion, in chemistry dispersion, in chemistry, mixture in which fine particles of one substance are scattered throughout another substance. A dispersion is classed as a suspension, colloid, or solution. of risk across the individual sellers disqualifies any one seller from being designed as the primary beneficiary because no one seller funds a majority of the conduit's expected losses or captures a majority of the residual gains on the program's assets. According to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. Fin 46 the primary beneficiary of a Variable Interest Entity must consolidate the VIE's assets with its own. Let's assume that twenty sellers finance assets through an asset-backed commercial paper program. Each seller funds $10 million of assets through the program at all times and each seller is required to finance the first 10% of losses on the outstanding asset pool ($1 million in out case or $10 million x 10%). A credit guarantee for 5% of the value of the assets financed by the program is issued by the bank which sponsors the asset backed commercial paper program. While each seller is in the first loss position financing a multiple of expected losses on the specific pool of assets it finances through the program, the total risk funded by the sponsor is $10 million (5% of S200 million) which is 10 times as large as any single seller's exposure. In our example the asset-backed commercial paper program is a variable interest entity (VIE) and the $10 million financial guarantee issued by the sponsor to fund losses is a "variable interest". We will refer to this hypothetical Hypothetical is an adjective, meaning of or pertaining to a hypothesis. See:
Financial Interpretation 46 (FIN 46) released by the Financial Accounting Standards Board Financial Accounting Standards Board (FASB) Board composed of independent members who create and interpret Generally Accepted Accounting Principles (GAAP). in January of 2003 and revised in December of 2003 interprets Accounting Research Bulletin 51 (ARB 51), Consolidated Financial Statements Consolidated Financial Statements The combined financial statements of a parent company and its subsidiaries. Notes: Because consolidated financial statements present an aggregated look at the financial position of a parent and its subsidiaries, they enable you to gauge , for its application to the consolidation of variable interest entities by business enterprises. While ARB 51 requires a business enterprise to consolidate subsidiaries in which it has a controlling interest controlling interest The ownership of a quantity of outstanding corporate stock sufficient to control the actions of the firm. Controlling interest often involves ownership of significantly less than 51% of a firm's outstanding stock because many owners fail , Fin 46 requires the primary beneficiary of a VIE to consolidate it. In ARB 51 controlling interests are measured in terms of voting rights Voting rights The right to vote on matters that are put to a vote of security holders. For example the right to vote for directors. voting rights The type of voting and the amount of control held by the owners of a class of stock. while FIN 46 focuses on the rights to receive residual value Residual value Usually refers to the value of a lessor's property at the time the lease expires. residual value The price at which a fixed asset is expected to be sold at the end of its useful life. and the obligation to fund expected losses. FIN 46 defines a financial entity as a variable interest entity if it has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or is financed by equity investors who can not make significant decisions about the entity's operations, or do not absorb the expected losses or receive the expected returns Expected Return The average of a probability distribution of possible returns, calculated by using the following formula: of the entity. Asset-backed commercial paper conduits generally meet the definitional criteria of a VIE. The equity of an asset backed commercial paper conduit owned but entities unaffiliated with the sponsor is minimal. Asset-backed commercial paper conduits are capitalized Capitalized Recorded in asset accounts and then depreciated or amortized, as is appropriate for expenditures for items with useful lives longer than one year. well below the level of expected losses and the equity does not cede the owner any decision making capacity regarding the operation of the conduit. The sponsor/administrator of the asset-backed commercial paper conduit controls the decisions regarding day to day and long term management of the conduit. Without the credit enhancement and liquidity support which is generally supplied to the conduit by the sponsor/administrator possibly through a syndicate Syndicate organized crime unit throughout major cities of the United States. [Am. Hist.: NCE, 2018] See : Gangsterism of financial institutions the conduit would not be financially viable. Fin 46 defines primary beneficiary of a VIE to be the entity which is exposed to the majority of the VIE's expected losses and/of the majority of expected residual returns. Citicorp like many banks that sponsor asset-backed commercial paper programs are reacting to FIN 46 by either restructuring restructuring - The transformation from one representation form to another at the same relative abstraction level, while preserving the subject system's external behaviour (functionality and semantics). the conduits they sponsor, winding down current programs or evaluating the economics of sponsoring asset-backed commercial paper programs when they must consolidate the conduit's assets and liabilities. Various restructuring possibilities exist that will enable the sponsor to avoid having to consolidate the asset-backed commercial paper program. One possibility is to compartmentalize com·part·men·tal·ize tr.v. com·part·men·tal·ized, com·part·men·tal·iz·ing, com·part·men·tal·iz·es To separate into distinct parts, categories, or compartments: "You learn . . . a conduit that is a VIE into separate silos which are in turn considered VIEs. Each silo would purchase assets from a seller just as a traditional asset-backed commercial paper conduit does. Financings for each silo have to be structured so that essentially the only source of repayment of the silo's liabilities are the assets owned by the silo and any credit enhancement supplied by the seller. By supplying the credit enhancement the seller becomes the primary beneficiary of the silo because it funds the expected losses of the silo and captures the residual value of the silo. As the primary beneficiary of the silo the seller must consolidate it. Other restructuring possibilities discussed in Fin 46: New Rule Could Surprise Investors, June 24, 2003, Equity Research, by Credit Suisse First Boston Credit Suisse First Boston was originally the trading name of the Financière Crédit Suisse-First Boston, a London-based 50-50 investment banking joint venture formed in 1978 between the First Boston Corporation and Credit Suisse. , are structuring the asset-backed commercial paper conduit as a QSPE, selling a majority of the credit risk of the VIE to a third party investor, or dispersing the risk and/or residual benefits of the VIE so that no single entity becomes the primary beneficiary. What has been the impact of Fin 46? We present an excerpt ex·cerpt n. A passage or segment taken from a longer work, such as a literary or musical composition, a document, or a film. tr.v. ex·cerpt·ed, ex·cerpt·ing, ex·cerpts 1. flora the Bank One Corporation, 10-Q for period ending September 30% 2003 in exhibit 1 to shed some light on the effects of Fin 46. Bank One is a significant sponsor of asset-backed commercial paper programs.
Exhibit 1
"Bank One Corporation, 10-Q for period ending
September 30th, 2003 "The Corporation is an active
participant in the asset-backed securities business where
it helps meet customers' financing needs by providing
access to the commercial paper markets through special
purpose entities, known as multi-seller conduits.
These entities are separate bankruptcy-remote corporations
in the business of purchasing interests in, and
making loans secured by, receivables pools and other
financial assets pursuant to agreements with customers.
The multi-seller conduits fund their purchases and
loans through the issuance of highly-rated commercial
paper. The primary source of repayment of the commercial
paper is the cash flow flora the pools of assets.
Investors in the commercial paper have no recourse to
the general assets of the Corporation. Customers benefit
from such structured financing transactions as these
transactions provide an ongoing source of asset liquidity,
access to the capital markets, and a potentially favorable
cost of financing.
As of September 30, 2003, the Corporation administered
multi-seller conduits with a total program limit of
$70 billion and with $34 billion in commercial paper outstanding.
The multi-seller conduits were rated at least A-1
by S&P, P-1 by Moody's and F-1 by Fitch.
These multi-seller conduits area type of variable interest
entity ("VIE"), as defined by FIN No. 46. These entities
historically have met all of the requirements to be accounted
for as independent entities, and, prior to the issuance
of FIN No. 46, were not required to be consolidated
with the Corporation. Each of the multi-seller conduits
administered by the Corporation prepares stand-alone financial
statements, which are independently audited on
an annual basis.
As administrator of the multi-seller conduits, the Corporation
provides deal origination services, asset portfolio monitoring,
treasury and financial administration services for these
entities. The Corporation structures financing transactions
for customers such that the receivables and other financial
instruments financed through the multi-seller conduits are
appropriately diversified and credit enhanced to support the
conduits' commercial paper issuances. As of the date hereof;
the Corporation docs not service these assets and does not
transfer receivables originated by the Corporation into the
multi-seller conduits it administers. Each conduit has program
documents and investment policies, which govern the
types of assets and structures permitted by the conduit. Three
of the multi-seller conduits principally purchase interests in,
or make loans secured by, trade receivables, auto loans and
leases and credit card receivables. One conduit makes loans
secured by portfolios of publicly rated marketable investment
securities.
The commercial paper issued by the conduits is supported
by deal-specific credit enhancement, which is structured
to cover more than the expected losses on the pool
of assets. The deal-specific credit enhancement is typically
in the form of over-collateralization, but may also include
any combination of the following: recourse to the seller
or originator, cash collateral accounts, letters of credit,
excess spread, retention of subordinated interests or third
party guarantees, in a limited number of cases, the Corporation
provides the deal-specific credit enchancements
as a financial arrangement for the customer. As of September
30, 2003 and December 31, 2002, the Corporation
provided such deal-specific enhancements to customers
in the form of subordinated interests totaling $134
million and $203 million, respectively. These subordinated
interest positions were included in loans on the
Corporation's balance sheets as of September 30, 2003
and December 31, 2002.
For three of the multi-seller conduits, the commercial
paper investors have access to a second loss credit protection
in the form of program-wide credit enhancement.
The program-wide credit enhancement consists of a subordinated
term loan from the Corporation and a surety
bond from an AAA rated monoline insurance company.
The subordinated term loans from the Corporation to
these conduits totaled $1.0 billion as of both September
30, 2003 and December 31, 2002. One conduit has only
deal-specific credit enhancements provided by other financial
institutions.
As a means of ensuring timely repayment of the commercial
paper, each asset pool financed by the conduits
has a minimum of 100% deal-specific liquidity facility associated
with it. In the unlikely event of a disruption in
the commercial paper market or in the event an asset pool
is removed from the conduit, the administrator may draw
on the liquidity facility to repay the maturing commercial
paper. The liquidity facilities art typically in the form of
asset purchase agreements structured such that the bank
liquidity is provided by purchasing, or lending against, a
pool of non-defaulted, performing assets. Additionally,
program-wide liquidity facilities and lines of credit are provided
by the Corporation and other financial institutions
to the multi-seller conduits to facilitate access to the commercial
paper markets.
As discussed on pages 44-46, the Corporation is an active
participant in the asset backed securities business where
it helps to meet customers' financing needs by providing
access to the commercial paper markets through special
purpose entities known as multi-seller conduits. These
multi-seller conduits are a type of VIE as defined by FIN
No. 46. These entities historically have met the requirements
to be treated as independent entities, and, prior to
the issuance of FIN No. 46, were not required to be consolidated
with the Corporation. The Corporation had previously
announced its intent to consolidate certain VIEs
related to its asset-backed conduit business in conjunction
with the implementation of FIN No. 46. As a result
of the Financial Accounting Standards Board's ("FASB")
deferral, the Corporation expects to consolidate or restructure
these entities in accordance with FIN No. 46 in the
fourth quarter. During the third quarter, banking regulators
issued interim regulations that provide risk-based capital
relief for certain assets that would be consolidated under
FIN No. 46."
The Federal Banking Agencies, Office of the Comptroller of the Currency The Office of the Comptroller of the Currency (or OCC) was established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States. (OCC OCC See: Options Clearing Corporation OCC See Options Clearing Corporation (OCC). ), Federal Deposit Insurance Corporation Federal Deposit Insurance Corporation (FDIC), an independent U.S. federal executive agency designed to promote public confidence in banks and to provide insurance coverage for bank deposits up to $100,000. (FDIC FDIC See: Federal Deposit Insurance Corporation FDIC See Federal Deposit Insurance Corporation (FDIC). ), Board of Governors of the Federal Reserve System Board of Governors of the Federal Reserve System The managing body of the Federal Reserve System, which sets policies on bank practices and the money supply. (FRB See Federal Reserve Board. ), and Office of Thrift Supervision The Office of Thrift Supervision (OTS) was established as a bureau of the Treasury Department in August 1989 as part of a major Reorganization Plan of the thrift regulatory structure mandated by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) (12 U.S.C.A. (OTS See Office of Thrift Supervision. ) have amended a·mend v. a·mend·ed, a·mend·ing, a·mends v.tr. 1. To change for the better; improve: amended the earlier proposal so as to make it more comprehensive. 2. the risk-based capital rules regarding the risk-based capital banks must allocate to finance ABCP ABCP Asset-Backed Commercial Paper ABCP Associação Brasileira de Cimento Portland (Brazil) ABCP Associação Brasileira de Ciência Política ABCP American Board of Cardiovascular Perfusion ABCP Associate Business Continuity Planner conduits that must be consolidated due to the implementation of Fin 46. The final regulatory rule, "Risk-Based Capital Guidelines guidelines, n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. ; Capital Adequacy Guide lines; Capital Maintenance: Consolidation of Asset-Backed Commercial Paper Programs and Other Related Issues", became effective September 30th, 2004. Without this amendment to risk based capital rules, banks would have had to allocate capital against the risk weighted assets of the conduit assets that were consolidated as a result of Fin 46. "Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Interim Capital Treatment of Consolidated Asset-Backed Commercial Paper Program Assets" does not exempt banks from counting the consolidated assets in their tier I leverage ratio. A bank's tier I leverage ratio is tier I capital divided by average total consolidated assets. Exhibit 2 lists the components of tier I and tier II capital.
Exhibit 2. Components of tier I and tier II Capital
Capital components are distributed between two categories (Tier 1 and
Tier 2). Tier 2 capital elements will qualify as part of a bank's total
capital base up to a maximum of 100% of that bank's Tier 1 capital.
Beginning December 31, 1992, the minimum risk-based capital standard
will be 8.0%.
Definition of Capital
Tier 1 :
Common stockholders' equity;
Noncumulative perpetual preferred stock and any related
surplus; and
Minority interests in the equity accounts of consolidated
subsidiaries.
Tier 2:
Cumulative perpetual, long-term and convertible preferred
stock, and any related surplus; (5)
Perpetual debt and other hybrid debt/equity instruments;
Intermediate-term preferred stock and term subordinated debt
(to a maximum of 50% of Tier 1 capital); and
Loan loss reserves (to a maximum of 1.25% of risk-weighted
assets).
Deductions from Capital:
From Tier 1:
Goodwill and other intangibles, with the exception of
identified intangibles that satisfy the criteria included in the
guidelines.
From Total Capital:
Investments in unconsolidated banking and finance
subsidiaries;
Reciprocal holdings of capital instruments[.]
Source: Office of the Comptroller of the Currency, 12 C.F.R. Part 3,
Appendix A
Banks rated in the top tier of the Uniform Financial Institutions Rating System by regulators must maintain a minimum tier I leverage ratio of 3% Banks that are receiving a rating below the highest must maintain a leverage ratio or at least 4%. The sum of tier I and tier II capital must be at least 8% of risk weighted assets. Risk weighted assets must be financed with a minimum of 4% of tier I capital. Minority interests in consolidated subsidiaries are generally included as a component of tier I capital. The Federal Banking Agencies amended the risk based capital regulations concerning asset-backed commercial paper programs because they believe that the capital bases of banks which sponsor asset-backed commercial paper programs art generally adequately protected from any losses that the assets financed by the program may experience. Regulators are confident that asset backed commercial paper programs are structured with sufficient collateral and credit and liquidity enhancements at the seller and program levels so that the risk to the sponsoring bank's capital base can be adequately financed if capital is held against any recourse The right of an individual who is holding a Commercial Paper, such as a check or promissory note, to receive payment on it from anyone who has signed it if the individual who originally made it is unable, or refuses, to tender payment. arrangements the sponsoring bank has with the asset-backed commercial paper program or any credit substitutes the bank has issued or invested in to enhance an asset backed commercial paper program. In summary if the risk based capital rules governing gov·ern v. gov·erned, gov·ern·ing, gov·erns v.tr. 1. To make and administer the public policy and affairs of; exercise sovereign authority in. 2. asset-backed commercial paper programs had not been amended to deal with Fin 46, banks would have been required to count the consolidated assets as risk weighted assets, in out previous "example I', assuming all of the assets funded through the asset-backed commercial paper program have a risk weight of 100%, the sponsor would have had to raise $16 million in equity capital to support the addition of $200 million of assets (8% x 100% x $200 million). Any credit enhancement and liquidity facilities it issued to support the program must be converted into on balance sheet assets, assigned as·sign tr.v. as·signed, as·sign·ing, as·signs 1. To set apart for a particular purpose; designate: assigned a day for the inspection. 2. the appropriate risk weight and then capitalized with regulatory capital. Liquidity facilities issued by banks to support asset backed commercial paper programs are generally structured to have maturities of less than one year so that the conversion factor is 0%. That is there is no capital charge on liquidity facilities that have maturities of one year or less. in conjunction with the interim risk based capital rules issued by the federal banking agencies to exempt sponsors of risk asset backed commercial paper conduits from having to consolidate the assets of the program, the banking regulators are considering assigning a 20%, conversion factor to liquidity facilities issued to support these asset-backed commercial paper conduits. Once converted to an on balance sheet credit equivalent, a risk weight that corresponds to the assets being enhanced is assigned to the liquidity facility. For a liquidity facility that supports a commercial paper program which funds trade receivables the risk weight would be 100% for the drawn amount of the facility. If the assets funded through the program were AAA AAA: see American Automobile Association. (Triple A) A common single-cell battery used in a myriad of electronic devices of all variety. Like its double A (AA) cousin, it provides 1.5 volts of DC power. When used in series, the voltage is multiplied. rated classes of asset-backed securities Asset-backed security A security that is collateralized by loans, leases, receivables, or installment contracts on personal property, not real estate. asset-backed security A debt security collateralized by specific assets. the risk weight attached to the used portion of the liquidity facilities would be 20%. An asset-purchase agreement issued to enhance the credit quality of an asset-backed commercial paper program is an example of a direct credit substitute. The conversion factor of this direct credit substitute is 100%. If the assets funded by the conduit have a 100% risk weight then the risk weight assigned to a direct credit substitute that has been converted to an on balance sheet credit equivalent amount is 100%. The required risk based capital is 8% x 100% of the principal amount of the assets supported by the direct credit substitute. Charles A. Stone, Universite Paris Dauphine dau·phine n. The wife of a dauphin. [French, feminine of dauphin; see dauphin.] Anne Zissu, Temple University |
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