2003 Interagency Accounting Seminar Asset Securitization

1. 2003 Interagency Accounting SeminarAsset Securitization FASB Interpretation 46 Consolidation of Variable Interest Entities (“VIEs”) March 20, 2003 Christopher Bianucci Partner (312) 879-2040 christopher.bianucci@ey.com Christopher Bianucci Partner christopher.bianucci@ey.com (312) 879-2040 Ernst & Young LLP 233 South Wacker Drive Chicago, IL 60606 !@

2. Accounting Overview

3. Accounting Overview Accounting for Securitizations… The Saga Continues • Statement of Accounting Standard No. 125 (issued in 1996) revised criteria for accounting for sales of financial assets and securitizations. • SFAS 125 introduced financial components approach and based balance sheet treatment on a control basis. • Adoption of SFAS 125 gave rise to need for 2-step transfers and “Qualifying” SPEs in order to achieve true sale criteria • SFAS 140 retained the fundamental concepts of SFAS 125 and clarified certain QSPE issues. Also expanded the disclosure requirements. • FIN 46, released in 2003, revised the framework for determining consolidation of variable interest entities.

4. Accounting Overview Sales Criteria • Surrender of control critical criteria. Paragraph 9 of SFAS 140 provides guidance on how to interpret a transaction for purposes of determining whether sales treatment is appropriate.\ • Must meet all of the following: 9(a) Transferred assets have been isolated from the transferor -- put presumptively beyond the reach of the transferor and its creditors even in bankruptcy or other receivership Generally, legal opinions will be required 9(b) Transferee obtains the right -- free of conditions -- to pledge or exchange the transferred assets or the transferee is a qualifying SPE and the holders of beneficial interests in that entity have the right -- free of conditions --- to pledge or exchange those interests and such pledge or exchange does not provide more than a trivial benefit to the transferor. Effect: Seller cannot restrict buyer’s ability to sell the transferred assets

5. Accounting Overview Sales Criteria (continued) 9 c The transferor does not maintain effective control over the transferred assets through: • An agreement that both entitles and obligates the transferor to repurchase or redeem transferred assets before their maturity, or • The ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (this could have a significant impact on deals with a revolving structure due to removal of accounts provisions (ROAPs) • Limited randomly selected accounts • Response to third party-controlled event • Defaulted contracts Effect:No Call options on unique assets

6. Accounting Overview Consolidation Considerations • Deconsolidation achieved in 2 ways: • QSPE • FIN 46 – applies to special purpose entities which do not meet the criteria of QSPE.

7. Accounting Overview QSPE • Qualified Special Purpose Entity (QSPE): • QSPE can be corporation, partnership, or trust. • QSPE’s can only hold • Passive financial assets transferred to it • Passive derivative financial instruments • Servicing rights related to the assets it holds • Activities of QSPE must be limited, specified in the documents that create it, and can only be changed by a majority of the 3rd party beneficial interest holders • Must be “demonstrably distinct” • At least 10% of its beneficial interests held by parties other than the transferor, its affiliates or agents • QSPE can only sell or dispose of noncash financial assets as an automatic response to a restricted list of conditions (servicing becomes very restricted)

8. Accounting Overview What is a Variable Interest Entity? • Entity that by design has: • Equity investment at risk not sufficient to finance its activities without additional financial support (5(a)), or • Equity investors do not have either- • Direct or indirect ability to make decisions through voting or similar rights (5(b)(1)), • Obligation to absorb expected losses (5(b)(2)), or • Right to receive residual returns (5(b)(3))

9. Accounting Overview VIE Decision Tree Is the total equity investment at risk sufficient? No yes No Do equity investors have the ability to make decisions about the entity’s activities through voting or similar rights? yes No Do equity investors have the obligation to absorb expected losses ? yes No Do equity investors have the right to receive the expected residual returns if they occur? yes Apply consolidation guidance of FAS 94 Entity is a VIE

10. Accounting Overview How Much is Enough? • At least equal to expected losses • At least 10% of assets, unless: • Entity can finance activities without additional subordinated financial support (9(a)), • Entity has at least as much equity as other entities that hold similar amounts of similar quality assets, and operate with no additional subordinated financial support (9(b)), or • Investment exceeds expected entity losses based on reasonable quantitative evidence (9(c))

11. Accounting Overview What Constitutes a Variable Interest? • Contractual, ownership, or other pecuniary interests that change with changes in VIE net assets (paragraph 2(c)) • Includes: • Equity and subordinated debt instruments issued by VIE • Senior Debt instruments • Loss guarantees • Servicing/Management contracts • other

12. Accounting Overview How do I know if I have to consolidate something? • The Primary Beneficiary of a VIE is the entity that is deemed to be the accounting parent and consolidates the VIE. • Entitled to more than 50% of expected VIE: • Losses, or • Residual returns • If different parties meet criteria, losses take precedence

13. Accounting Overview Primary Beneficiary Decision Tree Does the entity absorb a majority of VIE’s expected losses? Yes No Does entity receive a majority of residual returns and no other entity absorbs a majority of expected losses? Yes No Entity is not PB – Do not consolidate VIE Entity is PB – Consolidate VIE

14. Accounting Overview Expected Losses Defined • Derived from expected cash flows, discounted and adjusted for market factors and assumptions (paragraph 2(b)) • Includes: • Expected variability in: • Net income or loss, • Fair value of assets if not included in prior item, and • Fees to: • Decision makers, and • Guarantors of substantially all VIE assets or liabilities (paragraph 8) • Decision maker directly or indirectly makes decisions that significantly affect VIE results (paragraph 14)

15. Accounting Overview How about an Example….

16. Accounting Overview Assumptions: Assume a pool of assets with a maturity of 1 year, funded by the following structure:

17. Accounting Overview Assumptions: The pool of financial assets, with a contractual cash flow of $1.0, have expected cash flows as follows:

18. Accounting Overview Computed Variability of Senior Interest

19. Accounting Overview Variability of Subordinated Interest

20. Accounting Overview Determination of Primary Beneficiary

21. Accounting Overview Reconsideration of VIE Status paragraph 7 • Only if: • Governing documents or contractual arrangements change, • Part or all of equity investment is returned, and parties other than equity holders become exposed to expected losses, or • Entity undertakes additional activities or acquires additional assets that increase expected losses • Not if losses exceed expected losses and reduce equity investment

22. Accounting Overview Reconsideration of Primary Beneficiary Status paragraph 15 • Non-primary beneficiary reconsiders if it’s primary beneficiary only if: • Governing documents or contractual arrangements change, • Contractual arrangements among parties change, • Acquires newly issued variable interests, or • A portion of former primary beneficiary’s interest • Primary beneficiary reconsiders if it is primary beneficiary only when it sells or disposes of all or part of its variable interest

23. Accounting Overview If Consolidation is required • If consolidation of a VIE is required: • Record assets of VIE at Fair Value (other than those transferred by the PB) • Record assets transferred by the PB at Book Value • Record Fair Value of liabilities assumed • Record Fair Value of minority interests in the VIE • If debit balance, record as extraordinary loss • If credit balance, reallocate to basis of assets

24. Accounting Overview Pre-Implementation Disclosure paragraph 26 • If reasonably possible a VIE will be consolidated or disclosed upon full implementation: • Nature, purpose, size, and activities of VIE, and • Maximum loss exposure from involvement • VIEs can be aggregated if separate reporting would not add material information

25. Accounting Overview Timing • Pre-Implementation Disclosure: • Financials issued after January 31, 2003 • VIEs created after January 31, 2003: • Immediately • VIEs created before February 1, 2003 whose primary beneficiary is a public company: • Quarters beginning after June 15, 2003

26. Accounting Overview Transition Provisions – existing transactions • Measure assets, liabilities and non-controlling equity in VIE at carrying amounts as if the Interpretation had been in effect as of the date enterprise first met the requirements to be the PB – if practicable to do so. If not practical to determine previous carrying value, record at fair value as of effective date. • Any difference between the net assets of the VIE and the previously recognized interest shall be recognized as a cumulative effect of an accounting change. Restatement of previous financial statements is encouraged but not required.