FASB Bombshell: FAS 140 to Eliminate QSPEs

The "qualified special-purpose entities" (QSPE) — those not unlike Enron-style SPVs in which many leveraged financial institutions have been placing transactions that may turn into giant losses — may no longer be allowed to be used for that purpose.

At least, that is the concern if a new FASB rule (FAS 140) gets passed.

From
U.S. Banker, comes this discussion:

"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…

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.

This is hyper-technical accounting stuff, but it has enormous potential impact on markets. There may be trillions of dollars worth of derivatives buried on banks’ QSPEs.

To grossly oversimplify, Banks have been using QSPEs to effectively boost their leverage and hence, their return on capital. Without the balance sheet constraints of the old days, banks were encouraged to create assets — by making lots of loans they shouldn’t have — that could, in theory, be sold off later. It hasn’t quite worked out that way.

QSPEs can have legitimate purposes — but they also can obfuscate the true financial condition of a bank or broker. The purpose is not to simply hide losses off balance sheet, but to get those assets off balance sheet so leverage/Tier 1 capital ratios look better. Essentially you can be much more leveraged than you appear, so that ratios like ROA and ROE look stronger than they would if they weren’t employed.

The author of this above article wonders if "The migration of exotics to the balance sheet may be inevitable." If he’s correct, it bodes poorly a quick recovery for the financials. They have years worth of leveraged derivatives on their books, and writing them down won’t be quick or painless.

9th inning? Hardly.

>

UPDATE June 5, 2008 10:05 am

A hedge fund manager friend suggest this research piece:

The FASB Wades Into The Securitization Swamp
The Accounting Observer,  Volume 17, No. 6: May 22, 2008
http://www.accountingobserver.com/Reports/tabid/59/Default.aspx

Its free with a trial subscription.

>


Previously:
FASB 157 — Delayed, or Not? (November 2007)  http://bigpicture.typepad.com/comments/2007/11/fasb-buncha-bit.html


Sources:

FASB Lobs a Balance-Sheet Bombshell
Joseph Rosta
U.S. Banker  |  June 2008
http://www.americanbanker.com/usb_article.html?id=20080527YPS0NT46&

Related:
FASB Seeks to Improve Accounting for Qualified Special Purpose Entities
Business Wire,  June 10, 2003 
http://findarticles.com/p/articles/mi_m0EIN/is_2003_June_10/ai_102964259

BENDING THE RULES   
Tim Reason   
CFO, March 2008   
http://www.cfoasia.com/archives/200803-07.htm

What’s Right and What’s Wrong With (SPEs), SPVs, and VIEs  http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

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What's been said:

Discussions found on the web:
  1. Stuart commented on Jun 4

    One wonders if what Dick Bove meant when he stated financials were a generational buy, is you would have to wait a generation to make any return on them.

  2. daniel commented on Jun 4

    i don’t know why you keep mentioning derivatives. aren’t actual assets placed in the SPEs. yes, they are impaired, collateralized, garbage assets, but i didn’t think derivative contracts were booked to the SPEs.

  3. BG commented on Jun 4

    You’ve got to know the Financial industry will be putting out a full-court press on blocking this new FASB ruling. Sunshine is their enemy at the moment.

    In all honesty, I don’t see how they could have picked a worst time to (potentially) throw more gasoline on the fire burning within. Sounds like another group of Einsteins finally woke-up.

  4. Tom F. commented on Jun 4

    If the accounting profession had any guts and integrity SIVs and the like would never have allowed from the beginning.

  5. DonKei commented on Jun 4

    And this doesn’t even cover FASB Statement 159 that allows firms to discount their liabilities as they teeter towards insolvency, paradoxically making them appear more profitable just as they implode.

    Why anyone trusts anything these financial firms say these days, with all the accounting chicanery going on, is beyond me.

    David Einhorn, Meredith Whitney, and a few others, get that the financial sector is a huge, over-leveraged house of cards soon to fall.

  6. VennData commented on Jun 4

    FASB’s mission? To stay just on the side of the self-regulatory line.

    To get this together starting from March is Herculean – during tax season no less! – or maybe in the case of this collection of green-eye-shade-donning nebbishes, who defend their turf up to the out-of-bounds line, it’s really Hercule Poirot-ean (nerd that he was.) FASB can read the ’08 polls, they must be scared down to their rubber sole shoes.

    Another thought, the non-recourse nature of home rentership… er… a… ownership is in actuality a form of off-balance sheet entity for the homeowner.

    Look for an off-year, mid-cycle update to the GOP’s inhumane ‘Bankruptcy Abuse and Consumer Protection Act of 2005.’ Maybe they’ll call it ‘The Family and Hearth Permanent Sanctuary and Safety Act,’ but not until they can find some nutty issues to distract the sheep… er… a… voters and get back in charge… maybe a tough-talkin’ Texan…

  7. Randy commented on Jun 4

    I would be very interested in seeing some data on how much time and effort different banks spend fighting this. I want to invest in the banks that spend little or no effort fighting it. That should be a good indicator that those banks believe that they are less exposed than the others.

    I hope that the bankers succeed in getting this reform delayed until we get out of this contraction. Let’s sit on this reform until we get 2-3 years in to the next expansion. Or let’s pass the reform with a 5-year warning, so that it doesn’t take effect until 2013, in order to give the banks time to get their houses in order.

    I don’t think that the current Fed will let the banks fail. So the real net effect here will just be more bad paper foisted on the Fed and the taxpayers, and more inflation due to the additional money being printed.

  8. Marcus Aurelius commented on Jun 4

    After such a long spell of fiscal mendacity, the honesty will kill us.

  9. Jack commented on Jun 4

    Can you imagine the horror streaking through auditors’ board rooms?

  10. Jim Haygood commented on Jun 4

    It was ever thus … wasn’t it? In the wake of a Bubble popping, regulatory prudence returns. But of course, the restoration of prudence in the midst of an asset liquidation unfortunately acts in pro-cyclical fashion, to accelerate it and perhaps to cause overshooting on the downside.

    How much more prudent it would have been to avoid creating a Bubble in the first place! But the Pied Piper Greenspan, and his acolyte Mishkin with the cone-shaped hat and curled-toe shoes, maintain to this day that Bubbles can be identified only in hindsight. Funny, Jeremy Grantham doesn’t seem to have any problem defining and identifying them in real time.

    Ron Paul for Fed Chairman!

  11. Francois commented on Jun 4

    Passage and strict implementation of this rule would be the death knell for…how many IBs? That would be a really bad time for that to happen.

    OTOH, what would be a very good time to happen is a thorough clean up of the upper crust at these institutions. The boot for CEOs, CFOs AND board of directors.

    Thus far, the only consequence has been ousting of a few, but with severance packages that can set anyone and their descendants set for life. That is painful? I don’t think so.

    If one believe in actions and consequences, the latter should inflict a fair amount of personal pain. The Japanese subtle bureaucratic harassment method would be a good teaching lesson for these clowns. For instance, every golden parachute in place should be submitted to an exhaustive judicial/IRS (pick your favorite) administrative review, while they’re put on hold in escrow accounts. Interesting stuff could be unearthed, and such a process can take a loooong time, especially if contested. *evil grin*

    The chance of this happening? Next to nil. Accountability, honor and all those quaint notions have been thrown out of the window a long time ago when it comes to the elites in this country and elsewhere.

    Still, it’d be nice to see some reckless actors squirm and moan for a change; the point being that actions should/must/do have consequences.

  12. Organic George commented on Jun 4

    I have often said that the lesson from Enron to the rest of the financial world was “Why didn’t we think of that”

    Greed has no boundaries

  13. Stuart commented on Jun 4

    Somehow I have the feeling they will find a work around this too, just like FASB 157 was supposed to address Level 1, 2 and 3 accounting fraud. Let Merrill book to income gains of debt re-valuation, some $4B worth, after-all the market must be right on what they’re worth. But when it comes to asset downgrades, no way is the market properly pricing them so we have to shuffle those off to L3 and keep them on the balance sheet. Funny how that works, eh. Fraudsters that belong behind bars. Side note: Merrill upgrading Lehman this morning. How thoughtful of them. No collusion there, right after the Lehman CEO vows to squash shorts. Nope, none at all. Merrill and Lehman doing the 69 bigtime and the MSM pumps it out right on cue. Disgusting.

  14. prostratedragon commented on Jun 4

    “This is hyper-technical accounting stuff”

    And yet the info that something that has been allowed off balance sheets might soon be forced onto them communicates so much to the layperson.

  15. KnotRP commented on Jun 4

    The Treasury says they believe in a strong dollar.
    The Fed says it’s going to fight inflation (& devaluation).
    FASB says it’s going to fight off-balance sheet abuse.

    They arestill writing confidence checks, but their credibility
    account has hit the overdraft limit.

  16. David Merkel commented on Jun 4

    This could be big, but I’m not sure that securitization would not occur via other means — it is too powerful of a concept to go away in entire.

  17. Vermont Trader commented on Jun 4

    The biggest lesson that I learned from ENE was that there is nothing more dangerous to a financial company than a loss of counterparty confidence.

    ENE was a financial after all.

    We have seen this with Refco, Bear Sterns, etc.

    They can implode so quickly….

  18. Michael F. Martin commented on Jun 4

    “They have years worth of leveraged derivatives on their books, and writing them down won’t be quick or painless.”

    How much more painful will it get? Isn’t it better to rip the band-aid off then to try and peel it off slowly?

    What? Are JPM and Merrill Lynch going to implode also?

    I find it refreshing to see that some folks within FASB are taking their duty to the public seriously for a change.

  19. Walonline commented on Jun 4

    In the vast majority of cases, it appears that accountants used SPEs as an opportunity for further fees.

    At the same time, the proposed FAS 140 provides a chance to return to a higher integrity level at the FASB. That is, if they don’t cave to pressures like they did with FAS 123.

  20. MarkTX commented on Jun 4

    It is amazing how all the people who
    have F&*Ked “the people” over have suddenly found GOD and are now going to
    do something to “make it all better”.

    Sounds like the same ol’ same ol’ we have been hearing for the last several years.

    The more things change, the more they stay the same.

  21. Guy Bazanos commented on Jun 4

    The lack of transparency seems to be the real issue. As the author noted, these assets are “unpriceable”. If they’re brought on the books of the financial institutions and aren’t priced correctly, the capital requirements won’t be correct either.

    I agree with Robert Pozen, who is quoted in the American Banker article, that there could be a “capitalization problem” if all of these QSPEs are brought on the balance sheet. FASB’s deadline of June, 2009 is way too soon. Citibank announced that it would take 2-3 years to divest nearly $500 billion in legacy assets. They couldn’t possibly comply with a June, 2009 deadline.

    From the American Banker article:

    “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.”

    “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.”

  22. ed buscemi commented on Jun 5

    The real question should be whether the QPSE is bankruptcy remote.

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