FIN 46 Adds Billions to Bank Balance Sheet
By PricewaterhouseCoopers
CFOdirect Network Newsdesk
22-April-2004
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In this post-Enron financial reporting environment, the Financial Accounting
Standards Board (FASB) is intent on putting certain unconsolidated Special
Purpose Entities (SPEs) onto consolidated financial statements.
The vehicle for achieving this is Financial Interpretation Number 46, Consolidation
of Variable Interest Entities (FIN 46) that was issued January 17, 2003 and, with
subsequent revisions, reissued on December 24, 2003 as FIN 46(R). FIN 46(R)
was intended to clarify certain provisions of FIN 46 and revise certain other
provisions.
In this "era of securitization" – when financial assets are transferred into, packaged
and marketed to investors as securities – the SPEs that have been created are
estimated to have a worldwide value of as much as a trillion dollars.
These Asset-Backed Securities, which include such vehicles as Asset-Backed
Commercial Paper Conduits, Collateralized Debt Obligations and others, are very
much a part of today's financial services landscape.
"Banks are big users of such SPEs and are particularly impacted," says Woody
Wallace, a Partner at PricewaterhouseCoopers LLP. "Many of those SPEs will
probably qualify as variable interest entities (VIEs)."
If so, the "primary beneficiaries" must be determined and those primary
beneficiaries – whether it be banks, bank holding companies, investment houses or
other financial institutions – are required to bring the VIEs onto their books to be in
compliance.
For its part, the banking industry has been keenly aware of this potential
ramification.
"A couple of the large banks and global financial institutions participated on different
working groups and provided comment during the Standard's development
process," says Chip Currie, Senior Manager in PwC's Structured Finance Group.
"They have committed significant resources to preparing for and adopting FIN 46
and FIN 46(R)."
But given the complexity of the Standard, confusion over how to comply, changing
deadlines, and updated guidance, this Interpretation has been a challenge for bank
CFOs and their staffs.
Changing the Playing Field
"The process of applying the Interpretation has been less than smooth," says
PwC's Mr. Wallace. He attributes that to varying interpretations. "There has been
inconsistent application of the Interpretation to similar entities because of a lack of
clarity on how to apply the underlying concepts. People have taken different views."
Tom Barbieri, Partner at PricewaterhouseCoopers LLP, notes that there is a degree
of vagueness on how to allocate expected losses and expected residual returns to
the different interest holders of a VIE to determine which is the primary beneficiary.
"That is making it difficult to understand how to comply."
Mr. Wallace adds that this can lead to completely different decisions -- using the
same facts about the same VIE -- as to which party is the primary beneficiary.
"There is definitely the potential for conflicting decisions, especially in the
commercial paper conduit market."
Generally considered a complex Standard that is both far-reaching and difficult to
adopt, FIN 46(R) has introduced new accounting terms, requires considerable
information gathering and analysis, and calls for complex calculations and decisionmaking.
Key concepts and terms are:
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VIEs: entities (defined as any legal structure used to conduct
activities or hold assets) that meet the consolidation requirements
of FIN 46(R).
Primary Beneficiary: the company (or, "enterprise") that reports a
VIE on its consolidated financial statements.
Expected Losses: present value of an entity's expected cash flow
risks.
Expected Residual Returns: present value of an entity's cash flow
benefits.
Of these, expected losses is especially important because it is a key calculation
that determines if an entity is a VIE and, if so, may identify the primary beneficiary.
At the core of the Interpretation is FASB's position "that if a business enterprise has
a controlling financial interest in a VIE, the assets, liabilities and results…should be
included in consolidated financial statements with those of the business interest."
Impacting Securitizations
The concept that led to this "era of securitization" dates to the 1980s and, as Mr.
Wallace describes it, became "a robust market" in the 1990s that today is "huge."
Through securitization, financial assets are combined and transferred into
negotiable securities via Special Purpose Vehicles, another name for SPEs.
In banking, these assets are generally receivables, such as loans and credit card
portfolios, and are the financial underpinnings of the securities. Examples of these
Asset-Backed Securities include:

Asset-Backed Commercial Paper Conduits that are vehicles setup to
access the commercial paper market. Loans are sold by "originators" to
these conduits, which then issue commercial paper offered to investors.
This raises funds for the originator with the receivable assets being held in
the SPE conduit. As payments are made on the loans, investors receive
income from the SPE and the entity's manager receives a management
fee. Compliance with FIN 46(R) may result in the consolidation of those
conduits determined to qualify as VIEs.

Collateralized Obligations are a class of asset-backed securities where
multiple parties sell different levels, or tranches, of debt into SPEs for
securitization. Collateralized Bond Obligations (CBOs) and Collateralized
Debt Obligations (CDOs) have bank bonds and debt instruments as the
underlying receivables assets. These vehicles are general market value
investments designed for appreciation. Collateralized Loan Obligations
(CLOs) have bank loan receivables as the underlying asset and are cash
flow investments. Any of the entities that qualify as a VIE under FIN 46(R)
must be reflected on the books of their primary beneficiary, if there is one.
Interpretation 46 Revisions
As banks and other public companies digested and began to apply the original
provisions of the Interpretation (FIN 46), questions and issues emerged.
The FASB responded with FIN 46(R) saying that "additional guidance is being
issued in response to input received from constituents regarding certain issues
arising in implementing Interpretation 46."
According to PwC's Chip Currie, "FIN 46(R) involves some clarifications and some
actual modifications to the model." These "clarifications and modifications" affect
banks and financial institutions in three particular areas:
Asset Management Activities. This focuses on the managers of CBOs,
CDOs, and CLOs and has the effect of "leveling the playing field" in
determining the primary beneficiary of these entities if found to be VIEs.
In the original Interpretation, asset managers of these entities – because of
the fees they received and their decision-making responsibilities – were
likely to be identified the primary beneficiary. Many banks serve as such
managers and their fees were being included in the calculations that
determine the primary beneficiary on a "gross" basis as opposed to other
variable interest holders whose calculations are based on "variability from a
mean." FIN 46(R) eliminates the requirement to include fees on a gross
basis.
In making this change, FASB said that the original Interpretation "did not
allow for a distinction to be made between a decision maker who is hired
merely to provide services and is compensated commensurate with the
level of effort required, and one who has the ability to reap the rewards
(and suffer the risk of loss) of his decisions."
This subtle change is significant, Mr. Currie says. By including the asset
manager's fees on a gross basis, the calculations "tilted" toward that asset
manager being identified as the primary beneficiary. "Now, equal treatment
is being given to all parties in making that determination," he observes.
Derivatives. Appendix B, "Variable Interest" has "been rewritten" in FIN
46(R).
That Appendix, through its subheadings, addresses how to identify variable
interest in:
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Equity Investments, Beneficial Interests and Debt
Instruments
Guarantees, Written Put Options and Similar Obligations
Forward Contracts
Other Derivative Instruments
Assets of the Entity
Fees Paid to a Decision Maker
"The original Interpretation provided some guidance on certain derivative
contracts," Mr. Currie says. "FIN 46(R) expands that with new words on
how to think about derivatives with SPEs and potential VIEs.
Trusts Preferred Securities. The third and perhaps most significant
impact of FIN 46(R) on banking pertains to trusts preferred securities
(TPS).
A TPS is a different type of securitization entity created by banks or bank
holding companies. It is organized as a business trust, or some other form
of SPE, and issues two classes of securities:
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Common securities that amount to a small percentage of
the trust's capital and all of which are purchased and held
by the bank.
Trust preferred securities that are sold to investors.
The proceeds are invested in deeply subordinated debentures of the bank.
Interest payments provide cash to pay periodic dividends to investors. The
subordinated debentures have a set maturity date and may be redeemed
under other circumstances.
Historically, these trusts were consolidated onto financial statements. The
trusts were structured so that banks could raise preferred share capital
through the vehicles and include the minority interest created in "Tier I
(core) Capital", supplementing traditional capital sources needed to meet
bank regulatory capital requirements. Depending on the structure and state
jurisdiction, some banking organizations also were able to realize some tax
benefits.
At issue with FIN 46 was whether TPS structures could continue to be
carried on a consolidated basis by banks because the trusts either served
as a source of capital or borrowed funds; or because investments were
made only in the "lower levels" of the trusts.
"The FASB has settled the debate," says Mr. Currie "To be in compliance
with FIN 46(R), your must deconsolidate most TPS structures from your
financial statements."
The deconsolidation of TPS structures from a bank's financial statements
due to the dynamics of applying the Interpretation was not anticipated by
many financial statement preparers.
Supervisory Perspective
The industry dialogue and developments that led to the Interpretation has
generated considerable interest among "the agencies" responsible for bank
oversight. These include the Federal Reserve Board (FRB), the Federal Deposit
Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS) and the Office
of the Comptroller of Currency (OCC).
At the heart of their respective regulatory missions are the safety, soundness and
capital adequacy of banks and the banking industry.
The agencies require banks to maintain Capital Adequacy Ratios to help monitor
and ensure the financial stability of individual institutions and the banking system.
That ratio is calculated as a percentage of Tier I Capital and Tier II Capital.
Tier I Capital is considered to be fully available to absorb unexpected losses. It is
called "core" capital and it results from stockholders equity, non-redeemable
preferred stock and minority interest, including those in Trust Preferred Securities.
Tier II Capital is considered to be generally available to absorb losses. In general, it
is composed of general loss reserves, subordinated debt and limited life preferred
stock.
Dan Weiss, Director of PwC's Regulatory Advisory Services says regulators view
accounting and financial reporting through a particular prism. "With any change in
accounting and disclosure requirements, they ask how will the information on which
examiner, bank management and public judgments of institution and banking
system performance be affected."
While respecting GAAP reporting, he notes that regulators "reserve the right to
require different reporting and capital treatment for safety and soundness
purposes."
Thus, there is considerable interest in how banks comply with FIN 46(R) and how
securitization structures are accounted for and reported on financial statements
going forward. The recourse requirements in risk-based capital rules that were
adopted to address retained or acquired risk in securitizations are an example of
supervisory adjustments to financial reporting for capital adequacy purposes.
This can be glimpsed from "instructions" issued on July 2, 2003 by the Federal
Reserve's Division of Banking Supervision and Regulation. It directs bank holding
companies to continue, for now, "to include Trust Preferred Securities in their Tier I
Capital for regulatory capital purposes…."
This guidance provides similar "standstill treatment" for the risk based capital
measurement of certain consolidated exposures arising out of the application of FIN
46, and by implication FIN 46(R).
The agencies, however, noted that the Tier 1 leverage capital measure, which
employs average on-balance sheet assets as defined by GAAP, would be impacted
for any consolidated balances. The standstill of the risk based capital treatment
structures affected by the Interpretation, in particular asset backed commercial
paper conduits, is expected to expire after the second quarter 2004. A revised
interim capital treatment proposal is expected during the second quarter 2004 to
become effective shortly thereafter.
How does that square with the FASB's Trust Preferred Securities position as
articulated in FIN(R)? Have the agencies reacted to FIN 46(R)?
"They are continuing to assess the capital policy and industry impact and, for the
most part, have maintained existing capital treatment guidance." says Dan Weiss.
Examples of the competing aspects that the agencies may be weighing are:
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The recognized benefits that qualifying TPS offer to bank issuers –
such as the availability to absorb losses even in times of stressful
conditions, and a means to diversify and make more cost effective
capital raising on the margin.
An objective to conform accounting and capital concepts where
possible and appropriate, including consistency to international
capital guidelines.
Some of the options that the agencies may be considering in clarifying the capital
treatment of FIN 46(R), impacted securitizations and TPS are:
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Maintaining the risk-based capital off-balance sheet treatment
consolidated positions.
Grand-fathering some, or all, existing TPS as Tier I capital and/or
providing a transition period to migrate qualifying TPS to Tier II
capital status.
Determining whether the subordinated debt concentration limit will apply to TPS
included in Tier II capital.
Compliance Timelines
As the Interpretation has evolved, so too have the compliance dates. For public
companies reporting on a calendar year basis, these deadlines can be viewed as
"phases."
Phase One: When issued by the FASB in January 2003, FIN 46 required that the
Interpretation be applied "immediately" to all new entities created after January 31,
2003. This requirement and deadline has never changed.
For existing entities – created before February 1, 2003 – that might qualify as a
VIE, the compliance deadline was "no later than the first interim or annual reporting
period beginning after June 15, 2003." In effect, a July 1, 2003 deadline.
Phase Two: Responding to questions for clarification and further compliance
guidance, FASB in October 2003 deferred that original deadline for existing entities.
Applying FIN 46 to those determined to be VIEs was deferred "until the end of the
first interim or annual reporting period ending after December 15, 2003." This
meant the compliance deadline was December 31, 2003.
Phase Three: FIN 46(R) was issued by FASB on December 24, 2003 and replaced
FIN 46. Compliance with the "provisions" of FIN 46(R) for existing entities
determined to be VIEs "is required in financial statements for periods ending after
March 15, 2004." Effectively a compliance deadline of March 31, 2004.
Despite the changing timelines and compliance dates, banks and financial
institutions have moved forward during 2003 and early 2004 with their compliance
strategies. For example:

In its 2003 Annual Report to Shareholders, J.P. Morgan Chase & Co. said
that it implemented FIN 46 effective July 1, 2003. "The effect of adoption
was an incremental increase in the Firm's assets and liabilities of
approximately $17 billion at July 1, 2003 and $10 billion at December 31,
2003. The bank said the increase primarily related to "…Firm-sponsored
multi-seller asset-backed commercial paper conduits…."
Also, J.P. Morgan Chase made reference to FIN 46(R) and said that "The
Firm will adopt FIN 46(R) at the effective date and is currently assessing
the impact of FIN 46(R) on all VIEs with which it is involved."

The PNC Financial Services Group, Inc. also adopted FIN 46 effective July
1, 2003. In its Form 10-K for fiscal year ended January 31, 2003, PNC said
that it complied with FIN 46 "…by consolidating those VIEs that
management believed were then subject to the standard and of which PNC
was considered at the time to be the primary beneficiary." The VIEs that it
consolidated onto its balance sheets included a multi-seller asset-backed
commercial paper conduit, collateralized debt obligation funds, limited
partnerships that sponsor affordable housing projects utilizing the Low
Income Housing Tax Credit and private investment funds organized as
limited partnerships or off-shore corporations.
PNC then adopted FIN 46(R) at the end of 2003. Reporting this in Form 10K, PNC said: "Application of the revised rules resulted in the Corporation
determining that it was no longer the primary beneficiary of certain VIEs. In
accordance with the transition provisions of FIN 46(R), the Corporation
deconsolidated certain entities effective July 1, 2003 that had previously
been consolidated as of that date under the provisions of FIN 46."

Bank One Corporation implemented FIN 46 effective December 31, 2003
and consolidated $39.6 billion of assets and liabilities related to its assetbacked conduit business according to its 4th-Quarter 2003 press release
(January 20, 2004). In that release, the bank said: "Interim regulations
issued by the banking regulators, which provided risk-based capital relief
for these assets, remained in effect. The adoption of FIN 46, therefore, did
not have a material impact on Tier I or Total Capital."
Thus, a sampling of the broad reach and differing affect that this Interpretation is
having on banking. While FIN 46(R) resolved some issues from the original
FIN 46 and clarified others, there remains uncertainty, differing views and
compliance questions – an environment that suggest that the full impact of FIN
46(R)
has yet to be fully realized.
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For more information on the impact of FIN 46 on the banking industry, please
contact the following PwC professionals:
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Woody Wallace at woody.wallace@us.pwc.com;
Tom Barbieri at thomas.barbieri@us.pwc.com;
Chip Currie at frederick.currie@us.pwc.com; and
Dan Weiss at dan.weiss@us.pwc.com.
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