Securitization: A Platform to Debate Accounting

By Kyle Richard and Melissa Kosiba

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The securitization market began in the early 1970s with the issuance of bonds backed by mortgage loans. Previously, the U.S. government had subsidized the mortgage industry by offering tax breaks to mortgage companies. Unlike banks, which can draw on liquid deposits when funds are needed quickly, companies that focus on lending have no way to raise quick capital. The only revenue such companies generate is through closing costs and amortized monthly payments. So, in the early 1970s, the government created secondary mortgage markets like the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (FNMA, or Fannie Mae) to give mortgage companies a way to increase the liquidity of their business, especially during economic downturns.

Around 1975, shortly after the development of a secondary mortgage market, Sperry Corporation decided to securitize its computer lease receivables. The market spread like wildfire. Car loans were securitized beginning in the early 1980s. Over a short span of about 20 years, the secondary securities market has grown into a billion-dollar industry.

The securitization industry has two categories. The first is mortgage-backed securities (MBS), which groups together first-mortgage loans, termed home-equity loans, home-equity lines of credit, and tax liens placed on residential property. The second type encompasses all other receivable assets, including automobile loans, outstanding credit card balances, student loans, small-business loans, lawsuit settlements, and future revenue generated by royalties. The kinds of assets that can be securitized are broad. In 2004 the outstanding issuance of securities totaled seven trillion dollars. Growth for 2005 is estimated at an astounding $750 billion.

Securitization Process

The mechanics of the securitization process are simple. The originator pools together a diverse group of receivables of varying durations, maturities, interest rates, and risk ratings, and moves them to a special purpose entity (SPE), or trust, established by the originator for this specific purpose only. The SPE, in turn, issues asset-backed securities (ABS) or MBSs, depending on the collateral corresponding to the receivable to investors on the open market. The ABS/MBS is divided into different classes (Class A, B, Z), which dictate the priority of repayment.

When the receivable security is removed from the balance sheet of the originator to a SPE, the asset value does not change. Once the security is issued by the SPE, the asset will increase in value. This is because the assets of the originator are worth more outside the company, to investors, than within it. It is crucial for the originator to know the relationship between external and internal value before entering into the securitization.

Once the SPE receives the asset from the originator, the asset is immediately considered off–balance sheet, and, therefore, bankruptcy-remote. Being “bankruptcy remote” protects the asset from the creditors of the originator. In the event of a bankruptcy, the assets would be protected from the bankruptcy estate. SPEs are sometimes termed BRSPE to emphasize this point. When the originator has received capital for its ABS/MBS, it will use the funds to originate new loans or to pay down existing unsecured debt.

Corporations that securitize assets derive several benefits. First, the asset is removed from the balance sheet. This allows for recognition of the gain or loss immediately, intentionally improving the originator’s current-year operating results. Second, the use of securitization reduces reliance on unsecured debt, specifically commercial paper. Third, it increases liquidity. Securitization is accepted as a low-cost/low-risk method of financing.

Looking specifically at the automotive industry, securitization has become the preferred method of raising capital. The credit ratings of North American automotive companies are too low to issue unsecured debt that would be beneficial; their poor rating would make this type of debt extremely expensive. Therefore, the captive finance companies, specifically General Motors Acceptance Corporation (GMAC) and Ford Motor Credit Corporation (FMCC), pool vehicle loans and sell them on the open market as ABSs. The securities are deemed “safe investments,” as both the vehicle loan and its collateral back the security bond.

The benefits to investors purchasing ABSs or MBSs are superior rates of return, event risk reduction, diversification, and increased liquidity. The securities are rated by credit rating agencies such as Standard & Poor’s and Moody’s. The biggest potential benefit is that the investor is assured that there is an actual tangible asset behind the security. In the case of automotive securities, the tangible assets are the vehicles and the vehicle loans.

Regulation of the Securitization Market

As the securitization market has grown, accounting standards have developed. In late 2000, FASB issued a new accounting standard to govern securitization, SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. SFAS 125, Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities, remained intact with the issuance of SFAS 140, but SFAS 140 made more specific provisions to dictate the origination and handling of SPEs, and FASB increased the amount of disclosure required by companies using the secondary securities market. SFAS 140 requires very specific disclosure of securitization and the reasons for securitization in all corporate financial statements, to ensure that securitization is not abused or in some way skewing the financial image of a corporation.

SFAS 140 creates a framework for securitization. According to this standard, assets that are to be securitized must be isolated beyond the transferor (or originating company) and its creditors. As mentioned previously, emphasis is placed on the creditors of the transferor to protect the securitized assets in the unfortunate event of a bankruptcy. By isolating the assets from the creditors, they are saved from the potential bankruptcy estate. In addition, the transferee (or buyer) receives full rights to do with the assets as it wishes. The transferor retains no control over the securitized assets. SFAS 140 establishes conditions for the transfer of the securitized assets, and includes considerations for SPEs.

SFAS 140 follows the current system of rules-based accounting standards. Specific criteria, or “bright-line” rules, are given that lay out the requirement to be met for a sale of assets to qualify as an off–balance sheet securitization. If the sale meets the criteria, then it can be removed from the corporate balance sheet and replaced with cash. If the sale fails just one criterion, then it must remain on the corporate balance sheet and its revenue will be recognized over the term of the receivable or the lifetime of the asset. Critics of the current rules-based system point out that accounting standards such as this, which generate a checklist of criteria for accountants and CFOs, are more concerned with the form of the accounting transaction. Critics claim that little attention is paid to the substance of the transaction, or to how the transaction affects the overall financial status of the company.

There are many reasons why principles-based accounting standards would be logical. First, they force companies to focus on the substance of the economic event, reducing opportunities to focus on form and, in turn, ignore the function of the transaction. Second, the principles would be more broadly based than the existing U.S. rules-based standards. The new system would require fewer, if any, exceptions, and would limit the need for implementation guidance. Instead of the 100-plus pages currently needed to explain current standards, principles-based standards might be as little as 12 pages long. A principles-based system would also increase the need for professional judgment, meaning that the preparer and the auditor would be held to a higher standard. Both parties would be focused not on checklists of accounting criteria, but on the substance of the transaction and the impact of securitization. Finally, principles-based standards would help avoid potential double-jeopardy issues that both preparers and auditors currently face with regard to the lack of detailed information.

The greatest negative impact of implementing a principles-based accounting standard is that the comparability between financial statements could be reduced because of varying interpretations. Investors would face greater difficulties as investment opportunities arose. The financial statements would be more grounded in the value of various transactions, but at times investors would be forced to undertake considerable research when making investment decisions. Furthermore, enforcement would be challenging. Additionally, principles-based standards would require a large number of disclosures in financial statements. The cost incurred during the change from the current rules-based standards might also be a deterrent. Accounting firms and publicly traded companies would likely challenge the change from a legal perspective, resulting in costly attorney fees and drawn-out litigation.

International Issues

The International Accounting Standards Board (IASB) has done a creditable job of creating order from chaos. Because the IASB operates on a “risk-over-rewards” concept, the countries that operate under the IASs have not experienced the level of accounting scandals that the U.S. has seen under FASB. The risk-over-rewards principle enacted by the IASB states that if the seller is absorbing the risk, then the seller receives the reward. Conversely, if the buyer assumes the risk, than the buyer benefits from the potential reward.

Implementing principles-based standards would improve the quality and transparency of financial reporting between a U.S.-based company and a foreign-based company. Such a change would show that the United States is prepared to focus on a global marketplace.

Throughout its lifetime, securitization has stimulated fierce debate. Because of its ability to manipulate income, corporations have, at times, abused securitization to improve their overall financial image. Enron was not the first company to hide its debt through securitization. In the early 1990s, less than 20 years after the invention of securitization markets, a greeting-card company used securitization to hide its failing financial health. Five years later, a small investment company was also caught red-handed using the securitization market to camouflage its financial problems.

Enron was, however, the most visible abuse in the history of securitization. Enron used SPEs to hide liabilities from creditors and investors alike. The SPEs in question met the criteria established by SFAS 140. Supporters of principles-based accounting cite Enron as an example of the AICPA’s Accounting Standards Board’s placing more emphasis on form than on substance. Despite their compliance in form, the substance of these SPEs effectively hid the financial failings of the corporation.

Since Enron collapsed, FASB has fought to focus attention on substance. In addition, the Sarbanes-Oxley Act of 2002 (SOA) increased corporate governance and the responsibilities of auditors. Internal audits are no longer the isolated responsibility of a specific department within a corporation. With SOA, audit committees must now be established and corporate officers must sign off on audits, vouching that the audit realistically expresses the health of the corporation. In December 2003, FASB also issued Interpretation 46, which addresses criteria for SPEs. This interpretation is principles-based in concept, as it focuses on the substance of the entity: who owns a majority interest and how the entity changes the financial picture of the company.

Future Debates Expected

There is no easy way to account for securitization. Because it is such a powerful tool for controlling income and cash flow, it is highly susceptible to abuses. Rules-based accounting standards tend to focus on the format of the transaction rather than on how the transaction changes the overall financial picture. However, rules-based standards are accompanied by implementation guidance and specified exceptions that dictate how transactions are handled. Auditors and accountants must use professional judgment, but only to a limited extent. With a principles-based system, although accounting professionals would be held to a higher standard and more focus would be placed on substance and on reward/risk observations, interpretations would vary across entities.

The U.S. will probably never move completely to principles-based accounting standards, due to potential cost and legal issues. Securitization, however, will continue to grow in popularity and use, which will result in many future debates over the handling of these transactions.