Here’s a headline for you:  We don’t know if a conventional CMBS securitization where risk retention bonds are retained by a B-buyer under an industry standard third party purchaser agreement achieves accounting sale treatment.  Failure of accounting sale treatment means the selling bank cannot book the gain and does not derecognize the underlying loans resulting in the entire portfolio of loans remaining on its balance sheet for both Generally Accepted Accounting Principles, or GAAP, and presumably, for risk based capital purposes.

As might have been said by that great philosopher of the 20th Century: “You cannot possibly be serious!”

Commercial Mortgage Alert broke the story on Friday, August 11th and so I’m finally going to talk about the issue.  I’ve been itching to do so since early June when I became aware of the problem but it really didn’t seem there was a lot of upside for a broad industry discussion of the problem back then while the auditors and the internal finance teams at our banks and other CMBS sponsors were still pondering the issue.  But, after a good deal of mulling and to-ing and fro-ing, it’s still not resolved so I think it’s time to bring fun with GAAP out of the closet.

For the uninitiated, here’s the situation.  Something that looks a lot like a sale from any commonsensical point of view, might not actually be a sale through the lens of GAAP.  GAAP is what the Financial Accounting Standards Board (FASB) says it is.  FASB is an independent private sector organization that is recognized by the Securities and Exchange Commission as the designated accounting standard setter for public companies.  The problem here is how sale accounting is defined in Topic 860-Transfers and Servicing of the Accounting Standards (a codification, with certain amendments, of FAS 166).  The Accounting Standards govern how auditors interpret generally accepted accounting principles.

Now we arrive at the problem.  In order to achieve an accounting true sale follow this decision tree (slightly simplified) for the answer:

  • If the seller has no “continued involvement” with the Buyer or with respect to the transferred assets you have a good sale.  Move on.
  • If the Seller has “continued involvement” with the Buyer or the transferred assets, then in order to get to sale treatment, the following three things all must be true:
    • there must be a legal true sale opinion or another basis for the auditors to otherwise become comfortable that the assets have been isolated from the potential bankruptcy or insolvency of the Seller; and
    • each transferee, or in the case of a securitization, each third party holder of a beneficial interest in the securitization, has the right to pledge or exchange the asset (or beneficial interest) it receives where no condition both constrains the transferee from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor; and
    • the transferor has abandoned effective control over the transferred financial assets (e.g. repurchase rights).

If all these things are true, then congratulations, you’ve got an accounting true sale.  If not, sale treatment fails.

The first and third legs of this test do not generally present problems in our structures, but, as you can see, the requirements for Third-Party Purchasers (TPP) under the risk retention rules stress the second leg of this test as the very nature of those requirements is to constrain the ability of the B-Piece buyer to pledge or exchange its interests in the Securitization.

On first blush, this looks like a daunting test for our TPP based risk retention structures to meet.

But perhaps not.  First, can anyone really say this is good accounting policy?  Conduit CMBS transactions are sales.  We call this a moving company business for a purpose.  It simply doesn’t make sense to conclude restricting the sale or leverage of a small piece of the capital stack done in order to comply with a new regulatory fiat should queer sale treatment.  I’ve never understood the second leg of this test anyway.  It seems to be a more subtle restatement of the perfectly legitimate question, which is the subject of the third leg: does the transferor have effective control over the transferred financial assets?  Why pick out restrictions on sale or leverage?   Why not hat size or proximity to a Confederate general’s statue?  It doesn’t make any sense.  Shouldn’t the fact that it doesn’t make a whole lot of sense matter to how financial statements are prepared?

Also, there are lots of really good textual arguments why this should not cause a securitization to fail sale treatment.  First, what’s continued involvement?  There is no definition of continued involvement in the guidance, but only this precatory observation:

Examples of continuing involvement with the transferred assets include, but are not limited to, servicing arrangements, recourse or guaranty arrangements, or agreements to purchase or redeem transferred financial assets, options written or held, derivative financial instruments that are entered into contemporaneously with, or in contemplation of, the transfer, arrangements to provide financial support, pledges of collateral, and the transferor’s beneficial interest in the transferred financial assets.

This ain’t that.  On the other hand paying a bunch of expensive lawyers to negotiate and prepare a lengthy legal document whose principal purpose is to prevent the transferor from either selling (for a time) or levering (except for full recourse debt) the B-piece and setting up a comprehensive monitoring procedure wherein the sponsor can monitor the performance of the  TPP seems on its face sort of continued involvement-ish.

I have heard some accounting chatter that the mere imposition of the TPP agreement represents continued involvement.  I have also heard a suggestion that while imposition of the TPP agreement might not constitute continued involvement, the mere act of monitoring the performance of the TPP might.

I have also heard that if the seller or any of its affiliates has any other role in the transaction (master servers or special servers or trust administrator or trustee, etc. etc.) that that constitutes continued involvement.  As the accounting guidance does not define continued involvement in any useful way we get to speculate.  So helpful.

As the TPP agreement is like none of the examples of continued involvement in the literature, we can certainly make an argument that the TPP is not the stuff of continued involvement.  If there’s no continued involvement, there’s no problem with sale treatment.  Problem solved.

We could also collectively conclude that a restriction on 5% of the interest in the securitization is not meaningful, is not material, and therefore should be disregarded.  We could also conclude that since the Seller is required to impose these restrictions by law, that should be the basis of an exemption.

The trouble is that common sense is no better guide for the application of GAAP than it is to the application of the tax code.  Our auditing friends, having been made remarkably conservative by a multi-year pattern of, let’s face it, being sued for almost anything and everything, are not big on stepping out in front of the crowd with bold interpretations of GAAP.

While perhaps the Big Four might find a way to get to sale treatment on these facts, I find it hard to see the auditors, by themselves, embracing any of these arguments for sale treatment.  If not, what next?  Well, we can go back to the FASB and get this fixed.  Right?  Not a good strategy.  Been there.  I was deeply involved in the industry’s engagement with the Board around the original FAS 166 back in 2005-6.  Let me tell you.  Our issue is a pimple on the backside of the bullocks in FASB land.  Way bigger fish to fry.  Getting the Board’s attention will be no small undertaking.  Also, they’re not impressed at all with an argument that the accounting treatment negatively impacts business transactions.  “We just count ‘em.  You design the deals.”  Even if they concluded this was a real issue that needed clarity, they would likely open “a Project”, but in Wilton, the completion of a Project could take years.  That’s particularly not helpful as we report quarterly.  Yes, FASB could step in and fix this and fix it quickly.  They have the power to do so in a heartbeat.  I’m not holding my breath.

Now for the real solution.  The SEC can fix all this.  The SEC has the power to simply declare what GAAP is. There’s simply no good policy reason to embrace the unintended consequences of the application of a standard written in 2009 to a rule that only became effective in 2016 and that ought to resonate with this Commission.  From any commonsensical perspective, these are sales and the SEC should do the right thing here.

Moreover, the SEC can do this by itself.  This is not a risk retention issue.  This doesn’t require the SEC to consult with the other five prudential regulatory agencies who all joined hands and developed the risk retention rule.  Getting through that maze, is as we’ve said many times in the past, extraordinarily difficult but here the SEC can simply act and it should. Clarifying GAAP around this issue in no way appears to me to negatively impact the coherence of accounting policy and the underlying good policy prescriptions that drive making distinctions between things that are sales and things that are in fact financings.  These are sales.  I hope the SEC will act soon.  Indeed, I believe they will mount the proverbial white horse this fall and get this done.  But time’s a wasting.  Winter is coming or, in this case, a date with Sarbox certification.