Rule Makers Remove CMBS Market's Accounting Linchpin

Until now, issuers of CMBS bonds would assemble a pool of mortgages and then create a Qualified Special Purpose Entity (QSPE), usually a trust, which would then issue bonds and sell them to investors in order to "buy" the loans from the issuer. The sub-institutional rated bonds and the first-loss position, or non-rated bonds, were sold to a "B-piece" buyer who typically acts as special servicer and has ultimate control of the disposition of the mortgages.

Qualifying special-purpose entities (QSPEs) generally are off-balance-sheet entities that are exempt from consolidation. The new standard eliminates that exemption from consolidation. Many qualifying special-purpose entities that currently are off balance sheet will become subject to the revised consolidation guidance in the proposal on consolidations of variable interest entities.

The new standard requires a company to provide additional disclosures about all of its continuing involvements with transferred financial assets. Continuing involvement can take many forms—for example, recourse or guarantee arrangements, servicing arrangements, and providing certain derivative instruments. The new standard also requires a company to provide expanded disclosures about its continuing involvement until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about transaction gains and losses resulting from transfers of financial assets during a reporting period.

It is the B-piece buyer who is severaly impacted by this new accounting rule as they will now have to record the full face value of the mortgages and related bonds as assets and liabilities on their balance sheets which will make B-piece investing unattractive.

So, in the event of a CMBS issuance, who will now buy the B-piece? The bottom line: If there are no buyers, there can be no CMBS!

And because this affects all legacy deals, what happens to the existing pool of B-piece buyers?

Following is an artcle that appeared in this morning's CREDirect.com.....for your edification.

Rule Makers Remove CMBS Market's Accounting Linchpin

Thursday, 14 January 2010
By John Covaleski, Commercial Real Estate Direct Staff Writer

A new accounting rule that requires B-piece buyers of CMBS loans to record on their balance sheets the entire value of the bonds they handle has taken effect.

The Financial Accounting Standards Board, or FASB, has formally codified its FAS 167 standard, which eliminates qualifying special-purpose entities, or QSPEs, an accounting concept that's been the linchpin for CMBS.

The QSPEs allowed controlling-class investors to buy bonds from transactions without having to book the entire deals on their balance sheets. That in turn has enabled bond issuers to sell, for accounting purposes, the loans that they packaged into CMBS. They otherwise would have to carry the bonds' entire value on their books.

FAS 167, which also sets new reporting rules for the securitization of other types of assets, applies to existing CMBS as well as new issues. An overview of the rule is available on FASB's Web site.

It foists the responsibility to record CMBS bonds' total values on their controlling class investors or other entities that receive significant fees for managing the bonds' performance.

Both those definitions apply to B-piece buyers.

The codified version of FAS 167 is virtually identical to what FASB proposed last summer, stoking widespread fear that CMBS issuance and management would be severely crippled.

The new rule means that a B-piece buyer of a bond consisting of hundreds of millions or billions of dollars worth of loans would have to record the bond's entire value on its balance sheet, even though it may only own a stake worth say 2-3 percent of that value.

"This issue has not changed since last summer. QSPEs are gone," said Tom Barbieri, a partner in the assurance services practice of accounting firm PricewaterhouseCoopers.

FASB, the accounting rule maker for the United States, had been considering reining in CMBS issuers' user of QSPEs ever since the Enron accounting scandal. The credit crisis that began in 2007 heated regulatory interest in the issue this go-round.

The rule technically took effect Jan. 1 for companies that report by calendar years, and the first fiscal year beginning after Nov. 15, 2009, for all other companies.

"For the most part, issuers are in a discovery process to see what's going to have to go on their balance sheets. We have yet to see a lot of discussion of how they will deal with the rule," Barbieri said.

Loopholes could emerge from the rule's later interpretations. Barbieri said there could theoretically be cases in which a servicer's stake in a bond is too small and the performance-based component of its fees too small to consider it a controlling investor.

To be sure, he said those cases would be rare and that the SEC will closely monitor the management of CMBS deals for changes made to sidestep FAS 167.

The rule may also be modified somewhat in negotiations that FASB is having with the International Accounting Standards Board regarding converging their respective rules. FASB has deferred money market funds from having to meet the FAS 167 rules until after the convergence project is completed later this year.

Meanwhile, the rule is expected to be a major and costly accounting headache for CMBS B-piece buyers. Rick Jones, chairman of the Commercial Mortgage Securities Association's political action committee, last summer noted, "It will be extremely expensive to meet these reporting standards and it will not make financial statements more understandable."

The FDIC last month issued its own rule that gives banks a year to phase in their implementation of FAS 167 so they can meet the agency's risk-based capital standards.