Originally posted by: LegendKiller
Originally posted by: Deleted member 4644
So first the transferor deposits the assets into an SPE. This is the first sale and meant to be a true sale. As per paragraph 83(a) of FAS140 the first transfer of interest to a special-purpose entity is designed to be a true sale. The transfered assets are likely to be judged beyond the reach of the transferor or its creditors even in a bankruptcy.
Then it sounds like that SPE then transfers the assets to another entity that allows an increased amount of credit protection. This level of protection does not allow for a true sale (hence why you did not want to have the first transferor directly linked to this stage). The protection is provided by retaining a junior beneficial interest which I assume means that the creditors could reach the holder of that interest.
This second stage is done to get the high rating so that it is actually investment grade (or something close) and can attract third parties.
Can this be elimited? As for the changes, I assume you are referring to "Qualifying Special-Purpose Entities and Isolation of Transferred Assets" amendments to FAS140.. which states "This proposed Statement would prohibit an entity from being a qualifying special-purpose entity (SPE) if it enters into an agreement that obligates a transferor, its affiliates, or its agents to deliver additional cash or other assets to fulfill the SPE's obligations to beneficial interest holders"..
and further "Finally, this proposed Statement also would: a. Require that a two-step transfer used to achieve legal isolation from transferred assets involve a qualifying SPE as the second step if the result of the transfer is issuance of"...
So I would think no, the two steps cant be eliminated.
The second step can actually be removed, there was a law passed in Delaware (IIRC), that allows for the elimination of the 2nd step. While the true-sale can fail on the 2nd step (considering the credit enhancement is provided by the 2nd step), it has never been successfully challenged.
FAS140: "The Board understands that the "two-step" securitizations described above, taken as a whole, generally would be judged under present U.S. law as having isolated the assets beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership."
^^ The above is damn important.
The most important part of FAS140 is Paragraph 9b, which is the actual qualifications for the QSPE. Most importantly is separate existence. However, other factors include the ROAPs provisions, which further isolates the assets in ensuring that the Seller/Transferor does not have a call on the assets. Essentially, assets can only be "put" back to the Seller/Transferor upon the actions of a 3rd party (delinquency, default) or, upon the realization of a breach of Representation and Warranty in the Servicing and Selling documents (false conveyance, secured chattle paper having incorrect secured priority due to UCC-1 filing problems...etc).
This is the heart of the current problem. If Servicer/Sellers modify mortgages too much it could be seen as a violation of the ROAPs provisions, especially if the S/S benefits from that modification (which they technically would if they hold the equity tranche or get a servicing right). However, current opinions are that the ultimate benefactors of the modifications would be the ultimate benefactors of the trust, the bondholders.
As for asset recognition.. Well Assets are benefits that are controlled by an entity, that have arisen from a past event, and future economic benefits are expected to flow. Assets should be recognized, according to the AASB Framework, when it is probable that future economic benefits will flow to the entity, and the asset has a cost or value that can be measured reliably.
FAS140: Derecognition of transferred assets is appropriate only if the available evidence provides reasonable assurance that the transferred assets would be beyond the reach of the powers of a bankruptcy trustee or other receiver for the transferor or any consolidated affiliate of the transferor that is not a special-purpose corporation or other entity designed to make remote the possibility that it would enter bankruptcy or other receivership (paragraph 83(c))."
FAS140 attempts to separate out the pieces of the pie. Each person who has a benefit of a piece of pie must recognize that piece. The common pieces of the pie are the Servicing asset, the Equity tranche (enhancement), the Interest Only strip, and the actual bonds themselves. The Equity tranche and the IO strip could technically be considered on and the same, but if they are separated by purchaser of each distinct piece, then they must be recognized separately.
Naturally, the problem with this situation is that the remaining pieces are subject to modeling risk which are highly assumptive. The equity tranche had to be rated by the Rating Agencies and have a certain amount of capital held against them. However, what if the enhancement levels are wrong?
The IO strip is usually present-valued based upon many assumptions (excess spread, prepayments, term, losses, delinquencies...etc), thus, it can go up or down in value dramatically. This is one huge reason why many companies get addicted to the FAS140 crack.
They can make "loose" assumptions of the IO strip for Gain on Sale (GOS) purposes initially. They take a huge revenue recognition up-front. However, over time, as the assumptions start to unwind (current situation), they try to play "catch up", thus they issue more and more GOS securitizations, recognizing more revenue. This crack addict experience is actually pretty common among large companies who securitize assets.
However, when the music stops you have a bigger problem than you initially started with.
The Servicing Right also introduces problems in the current environment. Since there are more troubled assets you spend more to service them.
So if you have the wrong type of transfer (no reasonable assurance that the assets are beyond reach), and still hold a beneficial interest, your risk profile is extremely high?
Correct. If you transfer the assets incorrectly (invalidating the true-sale), you place the assets within reach of creditors. If your QSPE doesn't follow all of 9b, or you violate other areas (9a or 9c) you can invalidate the sale treatment and bring them back on BS (which doesn't mean that you are completely as risk of consolidation for legal/creditor purposes).
Maintenance of the true sale is very important.
In further reading, I found that retained interests normally have a different risk profile compared to assets transferred in securitization.
Correct, the remaining BI is pretty risky as it is usually the first-loss piece.
And I have no idea how you estimate the residual piece, but I assume it has something to do with CDO2 ? As for the servicing rights.. can't they be sold to anyone?
CDO^2 is something that they use to de-recognize the first loss piece (equity tranche and(sometimes) the IO strip)
On a side note, I found literature that states that FAS140 requires that any derivative "pertain" to third-party beneficial interest holders. What does that mean?
The question of derivatives is an interesting one. Many trusts will utilize interest rate swaps to mitigate fixed-rate assets causing interest rate exposure when the bonds are floating rate. If the swap if for the benefit of the trust it is OK. However, considering that the Servicer/Seller still has benefit of the IO strip, they can also benefit from the swap. The determination is where the swap is in the waterfall of the documents. If it is at the top, then it's usually construed as being for the benefit of the bondholders. If it is towards the bottom of the waterfall, particularily after the interest on the bonds is paid, it can be considered to benefit the Servicer/Seller and could violate FAS140 treatment.
Please be a bit more specific about capital implications.
The main benefit to FAS140 treatment is consideration of assets off of a bank's balance sheet. If all assets are recognized, capital must be held against ALL assets. Banks have targeted reserve amounts, different risk categories of assets will have different treatment. A AAA asset, according to BASEL II, will have a 7% Risk-Weighted-Asset consideration if it is a senior tranche. Capital must be held against that, determined by the target capital ratio, if it is, say, 10%, then you have to hold .7% of capital against the position (7%*10%).
As you can see, if you can de-recognize the assets, the less capital you have to hold (and more another entity has to hold).
Additionally, assets have loss provisions set aside to account for defaults. The bank doesn't have to hold any reserves for those potential defaults if they get it off-bs.
Thus, a S/S only has to hold capital for the retained BI, usually the equity tranche. They went one step further by CDO'ing out those pieces, further limiting their capital requirements.
And as for an SPE vs a QSPE, I think the most impt difference is that a QSPE can't hold equities, enter into a derivative transaction with a transferor, or an agreement that commits the transferor to deliver cash or other assets to the QSPE or any beneficial interest holders. (Servicing advances are OK).
It isn't just that they can't hold equities. They can't hold almost anything. They can only hold homes, cars, or other non-financial instruments for a short period of time for foreclosure and sale. Otherwise the maintenance, insurance, and other "active" points they have to do to maintain those assets, performed by the Servicer/Seller, could violate the "brain dead" aspect of the QSPE. That is of utmost importance, the QSPE cannot be any type of "real" corporation, it has to be completely inert.
You see now why I consider FAS140 to be a huge piece of the current problem. It doesn't put recognition of the assets into the hands of really anybody, it shuffles the hot potato. It encourages riskier loan origination (to get more GOS). It hides actual potential losses. It undermines capital positions.
This is why reading a book, or a regulation, isn't enough. You have to live, breath, work this stuff to understand the full implications of such policies. Most importantly, you have to be honest with yourself and your morals to understand the problems with what may or may not be happening. That can only be found in actual first-hand experience in working in the field.
It is one reason why most books on these subjects fail, they aren't written by people who really understand the situation. It's also one reason why I have been considering writing a book on this stuff.
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