US Banker  |  June 2008

By Joseph Rosta

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Losses tied to banks’ off-balance-sheet subprime-mortgage investments have reached into the hundreds of billions of dollars and caused some real soul searching among the nation’s top accounting group, The Financial Accounting Standards Board, which has moved quickly to radically alter the rules for how banks must account for so-called qualified special-purpose entities, or QSPEs.

Reform is needed and probably inevitable, but is FASB moving too fast? Some banks may sit on QSPEs, whose values are almost equal to their balance-sheet assets, analysts say. Forcing financial institutions to load up their balance sheets too soon with these still largely untradeable holdings could prolong the financial market’s misery.

The IMF, The Bank of England, the Securities and Exchange Commission, the President’s Working Group and other groups have jumped on the reform bandwagon. And since March, FASB staffers have been gathering data and assessing whether risk was masked under current accounting rules used by banks for securitized investment vehicles, collateralized debt obligations and other toxic instruments currently languishing in an illiquid market.

Now comes a rather under-the-radar bombshell. FASB has decided to “eliminate the concept of the QSPE” in the revised financial-accounting standard, FAS 140, and also will “remove the related scope exemption from FIN 46R,” says FASB director of technical activities Russ Goldin. FASB is sill studying actual implementation and disclosure issues, but it seems pretty clear those unpriceable, lamentable assets are headed for the balance sheets.

Final FASB board deliberation is expected this month, with a public comment period starting in July, followed by a roundtable, at which critics are invited to “meet publicly with the board and debate,” Goldin notes. The changes could be finalized by late in the third quarter. The effective date: June 2009.

That timeframe is a blink of the eye. Consider Citigroup, which told shareholders in May that it would divest nearly $500 billion of legacy assets in two or three years. A sizeable chunk of that is QSPE material, according to analysts — and would not be a welcome sight on Citi’s balance sheet. Several other money-center banks could face peril as a result of the rule change.

Robert C. Pozen, chairman of financial-advisory company MFS, warns that FASB may be going too far. He argues that QSPEs serve a legitimate purpose and are not the sole province of scoundrels. “The function of off-balance-sheet treatment is to increase the funding of instruments that can be commoditized and allow more diversification,” he says. If banks had to include QSPEs on the balance sheet, “they’d max out pretty quickly” in their ability to extend financing.

Pozen says the push for greater transparency is worthwhile, but he believes that there can be much better disclosure without forcing exotics on the balance sheet. For some institutions, bringing all QSPEs onto the balance sheet could create a “capitalization problem,” he says.

Tanya Azarchs, managing director at Standard & Poor’s, disputes that. She expects that capitalization problems, overall, should be muted. S&P has always regarded QSPEs “as if they were on balance sheet, so it would be good if GAAP (Generally Accepted Accounting Principles) also required it,” she says. “The question is whether banks entered into [QSPEs] to avoid capital requirements or as a funding mechanism,” she explains. “If the latter, the change shouldn’t matter. Even if the former, it depends on whether regulators change their treatment under their risk-weighted assets measures.”

Pozen, for his part, supports a “middle road” where disclosure standards are only toughened. Under current rules, exotic securities become “orphan trusts—nobody claims to own them.” Revised rules would make ownership clear. Another key change he’d like to see: Have a large investor choose the rating agency and assure an accurate rating system and monitoring. “Today, the sponsor runs that aspect — the marketer, who often has no stake in the product at all,” Pozen complains.

The migration of exotics to the balance sheet may be inevitable. If so, the key is to make sure the path is constructive, and that includes a more gradual implementation of the new rules that FASB currently proposes. The world cannot afford another shock to the global financial markets. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.us-banker.com http://www.sourcemedia.com

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