Securitization Accounting Under FASB 125 - Securitization.Net

SECURITIZATION ACCOUNTING UNDER FASB 125 Y2K EDITION / JANUARY 2000
fasb
125
Securitization Accounting Under FASB 125
by Marty Rosenblatt and Jim Johnson

To our clients and friends:
Who would have thought that securitization accounting would be such a dynamic topic? The FASB,
the EITF, the FDIC, the AICPA and the SEC have proposed and promulgated rules, policies and interpretations
at a relentless pace, necessitating a fourth edition of our booklet. As with the prior editions,
this booklet is written in general terms as a guide only. The actual application of FASB 125
should be determined by all relevant facts and circumstances, and we recommend that readers seek
up-to-date information regarding any particular problem they encounter.
Equity analysts and rating agencies have been extremely critical of the quality of earnings of many
securitizers. They point out that FASB 125 gains are, for the most part, paper profits. They characterize
gain-on-sale accounting as front-ending income by recording "soft" assets that represent an
estimate of the present value of anticipated income. In response, several securitizers have reported
that they would adopt more conservative assumptions, while others have recently announced that
they would discontinue the use of gain-on-sale accounting altogether.
However, in order to report a zero up-front gain, the securitization must be structured as a financing
rather than a sale in virtually every case. This debt-for-GAAP treatment has most commonly been
implemented by inserting a call option that is not just a cleanup call. Management often objects to
debt-for-GAAP treatment because the balance sheet balloons with debt which has negative implications
on debt/equity ratios, return on assets and debt covenant compliance.
The FASB continues to maintain that “gain [or loss] on sale” accounting is the most appropriate (and
conceptually sound) treatment whenever a sale has occurred, and that FASB 125 contains appropriate
guidance for determining whether a sale has occurred, and for recording the retained interests.
To resolve this conflict, our firm has encouraged the FASB to consider adopting for certain securitizations
a “linked presentation” approach, in which the “pledged” assets remain on the balance
sheet but the non-recourse securitized debt is reported as a direct deduction from the pledged assets
(rather than as a liability). At the time of this writing, we have no indication that the FASB will give
serious consideration to our proposal, but we remain hopeful.
In the meantime, the FASB has proposed extensive new disclosures relating to securitizations
accounted for as sales, including the number and volume of transactions, cash inflows (outflows)
with the securitization trusts, disclosure of prepayment, loss, discount rate and other assumptions,
static pool loss analysis and multiple stress tests or sensitivity analyses for the value of the retained
interests. Some securitizers provide supplemental information showing key financial statement
components on a pro forma basis, as if their off-balance sheet securitizations were on balance sheet.
The FASB considered, but rejected, this type of presentation as a required component of the new
disclosures.
We make a constant effort to stay current in this ever-changing market, and hope that this effort is
reflected in the following pages. At the time of this writing, the FASB has proposed significant
amendments to FASB 125, which we cover starting on page 42 of this booklet. If adopted, the
amendments (currently expected in the second quarter of 2000) are likely to become effective in
2001. Accordingly, readers should not apply the guidance in this booklet post-2000. We have shaded
the areas in this booklet where the rules are scheduled to change as a result of the proposed
amendments to FASB 125. We intend to prepare another edition of this booklet when the new rules
are adopted in final form.
Thank you for your continuing interest. We look forward to providing further updates in the months
and years ahead.
Sincerely,
If you would like to receive our periodic bulletin, S.O.S.-Speaking of Securitization, covering accounting,
tax, regulatory and other developments affecting the securitization market, just send an e-mail to
sst-los_angeles@dttus.com.

fasb
125
Securitization Accounting Under FASB 125
Y2K
EDITION
JANUARY 2000

SECTION SECTION
SECTION
SECTION
1
2
3
4
What is FASB 125, and when does it apply?
FASB 125 applies to: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
FASB 125 does not apply to: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Determining whether the securitization meets
the sale criteria
When is a securitization accounted for as a sale? . . . . . . . . . . . . . . . . . . . . . 6
What about puts and calls? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Must a qualifying special-purpose entity be “brain dead”? . . . . . . . . . . . . . . 8
Do QSPEs get consolidated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
What if the issuer is not a QSPE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11
Is it possible to structure debt-for-tax as a sale for GAAP? . . . . . . . . . . . . . 11
Can warehouse funding arrangements be off-balance sheet? . . . . . . . . . . 13
Can I convert loans to securities on my balance sheet? . . . . . . . . . . . . . . . .15
Why do the assets have to be isolated? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Do banks have to isolate their assets to get sale treatment? . . . . . . . . . . . . 16
Do I always need a lawyer’s letter? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Can a QSPE ever sell its assets? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
What if the transfer does not qualify as a sale? . . . . . . . . . . . . . . . . . . . . . . 21
And if it does qualify as a sale? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Questions related to determining gain or loss on sale
Can I elect not to recognize gain on sale? . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
What if I can’t reasonably estimate fair value? . . . . . . . . . . . . . . . . . . . . . . . 28
How is gain or loss determined in a revolving structure? . . . . . . . . . . . . . . 28
How about an example of a gain on sale
worksheet or template? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
How about a credit card example? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Is fair value in the eyes of the “B-holder”? . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Does FASB 125 guide the separate financial
statements of the SPE? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Can I record an asset for servicing? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Should I record a liability for retained credit risk? . . . . . . . . . . . . . . . . . . . . 35
How are cash reserve accounts handled? . . . . . . . . . . . . . . . . . . . . . . . . . . 36
How does FASB 125 treat interest-only strips? . . . . . . . . . . . . . . . . . . . . . . . 37
Are there any special rules for mortgage bankers? . . . . . . . . . . . . . . . . . . . 39
What if we put Humpty-Dumpty back together again? . . . . . . . . . . . . . . . . . 40
Stay tuned for further developments
What’s slated for 2001? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
The FASB’s proposed new disclosures . . . . . . . . . . . . . . . . . . . . . 45
Test your knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Index

what is
fasb
125
AND WHEN DOES
it
APPLY?

4
The Financial Accounting Standards Board’s Statement No. 125, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, went into effect starting with
1997 transactions. 1 The FASB staff and the Emerging Issues Task Force (EITF) are faced with the
task of trying to keep pace with the continuous innovations in the securitization market, and
have created additional materials intended to help apply FASB 125 to a variety of circumstances. 2
FASB 125 APPLIES TO:
• public and private companies;
• public and private offerings; and
• all transfers of financial assets.
FASB 125 DOES NOT APPLY TO:
• transfers of non-financial assets such as operating leases, servicing rights, stranded
utility costs, or sales of future revenues such as entertainers’ royalty receipts;
• investor accounting rules (but see discussion of Interest-Only strips and other securities
subject to prepayment risk);
• income tax sale vs. borrowing characterizations or tax gain/loss calculations; 3
• regulatory accounting or risk-based capital rules for depository institutions; 4
• statutory accounting or risk-based capital rules for insurance companies; 5
• accounting principles outside of the United States (but FASB 125 does apply to
transactions by foreign subsidiaries in consolidated financial statements of U.S.
multinationals and foreign companies that follow U.S. GAAP, usually for SEC
securities filings). 6
1
SECTION
1. This booklet addresses only securitizations. It does not address other transactions covered by FASB 125, such as
repos, dollar rolls, securities lending transactions, wash sales, loan syndications, loan participations, banker’s acceptances,
factoring arrangements and debt extinguishments, including in-substance defeasances of debt.
2. The FASB staff has codified the status of each prior EITF consensus affected by FASB 125. This can be found in Topic
D-52 of the EITF Abstracts. Also, they have prepared a Special Report, A Guide to Implementation of Statement 125,
Third Edition, which contains well over 100 questions and answers (The FASB 125 Q&A Implementation Guide).
3. The Financial Asset Securitization Investment Trust (FASIT) tax legislation became effective September 1, 1997, but
FASITs have not been popular vehicles and tax regulations have not yet been issued. Also see page 22.
4. Federally chartered banks are required to follow generally accepted accounting principles (i.e., FASB 125) when preparing
Call Reports. However, pursuant to the risk-based capital rules, in asset sales in which the bank provides recourse,
the bank generally must hold capital applicable to the full outstanding amount of the assets transferred. The “low-level
recourse” rule limits the risk-based capital charge to the lower of (a) the bank’s maximum contractual exposure under
the recourse obligation (e.g.,the book value of a spread account or subordinated security) or (b) the amount of capital
that would have been required, had the assets not been transferred. The Office of the Comptroller of the Currency and
the other bank regulatory agencies are currently considering the regulatory capital treatment for sales with recourse and
are planning to issue a notice of proposed rule making on that subject.
5. The National Association of Insurance Commissioners (NAIC) has adopted, in Statement of Statutory Accounting
Principles No. 33, the securitization guidance in FASB 125 except (a) sales treatment is not permitted for transactions
where recourse provisions or call or put options exist and (b) servicing rights assets are nonadmitted assets.
“Recourse” for these purposes does not include the retention of a subordinated class in a securitization.
6. Our firm has compiled descriptions of the accounting for securitizations in 33 countries. Excerpts are included in the
1999 Annual Database published by International Securitisation Report, and can also be obtained by contacting
Frank Dubas, Deloitte Touche Tohmatsu – New York, +1 212 436 4219, fdubas@dttus.com.

determining
whether
the
SECURITIZATION MEETS THE
SALE
CRITERIA

6
WHEN IS A SECURITIZATION ACCOUNTED FOR AS A SALE?
A securitization of a financial asset, a portion of a financial asset, or a pool of financial
assets in which the transferor (1) surrenders control over the assets transferred and (2)
receives cash or other proceeds (other than beneficial interests in such assets) is accounted
for as a sale. The transferor is considered to have surrendered control in a securitization
only if all three of the following conditions are met:
1. The transferred assets have been isolated from the transferor — put beyond the reach of the
transferor, its affiliates and their creditors (either by a single transaction or a series of transactions
taken as a whole) even in the event of bankruptcy of the transferor. [9a and 23] 7
This is a “facts and circumstances” determination, which includes judgments about the
kind of bankruptcy or other receivership into which a transferor or Special-Purpose
Entity might be placed, whether a transfer would likely be deemed a true sale at law,
and whether the transferor is affiliated with the transferee. In contrast to the “goingconcern”
convention in accounting, this possibility of bankruptcy must be dealt with,
regardless of how remote it may seem in relation to the transferor’s current credit
standing. For example, a double-A rated issuer of auto paper must take steps to isolate
the assets in the event of bankruptcy and cannot simply say that there is no way that
issuer bankruptcy could be a problem during the relatively short term of the securitization.
Why do the assets have to be isolated? See page 15.
2. The transferee or, in a two-tier structure, the second transferee, is a qualifying special-purpose
entity (QSPE) (see definition on page 8) and the holders of debt and equity securities in that entity
have the right to pledge and/or exchange those securities. If the issuing vehicle is not a qualifying
SPE, then sale accounting is only permitted if the SPE itself has the right to pledge and/or
exchange the transferred assets. [9b]
The qualifying status of an SPE is extremely important because, generally, a QSPE does
not have to be consolidated, while a non-qualifying one may need to be consolidated.
See discussion on page 10, entitled: Do QSPEs get consolidated?
Note that in a two-tier structure, the entity that issues the securities (e.g., the trust)
needs to be the QSPE. The “intermediate SPEs” (e.g., the Depositor) are typically not
considered QSPEs. As long as the “issuing SPE” is a QSPE, the nature of the intermediate
entities should not affect the accounting treatment for consolidation purposes.
2
QSPEs are basically designed to operate on “automatic pilot.” Must a QSPE be braindead?
(See page 8.) At inception, the SPE hires a servicer (generally the transferor) to
collect payments on its assets. It also hires a trustee to administer and oversee its undertakings,
and may engage the services of an advisor to identify appropriate investments
7. Numbers within brackets refer to paragraph numbers of FASB 125.
SECTION
Shaded information is scheduled to be amended by the Exposure Draft of the proposed amendments to FASB 125.
See Section 4 – What’s Slated to Change in 2001.

for temporary excess funds. The substantive investor protection features of a highly
rated securitization are designed to prevent the seller from altering significant terms
without the investors’ consent. Holders of an SPE’s securities are sometimes limited in
their ability to transfer their interests, due to a requirement to only transfer a security
if an exemption from the requirements of the Securities Act of 1933 is available. The primary
limitation imposed by Rule 144A, that a potential buyer must be a sophisticated
investor would not preclude sale accounting if a large number of qualified buyers exist
so that holders could transfer their beneficial interests.
3. The transferor does not effectively maintain control over the transferred assets by an agreement
that entitles (or both entitles and obligates) the transferor to repurchase the transferred assets. [9c]
A cleanup call is permitted and is defined as: a purchase option held by the servicer,
who may be the transferor, which is exercisable when the amount of outstanding
assets falls to a level at which the cost of servicing those assets becomes burdensome.
[243] See further discussion of cleanup calls in the next section. An agreement that both
entitles and obligates the transferor to repurchase the transferred assets (e.g., an automatic
rather than optional repurchase) maintains the transferor’s effective control over
those assets and, therefore, is generally accounted for as a secured borrowing. [27]
Other considerations apply if the transferred assets are “readily obtainable elsewhere.”
Rarely are assets that are transferred in securitizations “readily obtainable elsewhere.”
WHAT ABOUT PUTS AND CALLS?
Determining whether the securitization meets the sale criteria
No quantitative guidance on the size of a cleanup call is set forth in FASB 125. Ten percent
of the transferred balances is generally viewed as the maximum for GAAP. Note that the
definition states that the option is held by the servicer. Also, the SEC staff has said that call
options on the debt or equity securities issued by the QSPE have the same effect as call
options on the transferred assets. [Topic D-63 of the EITF Abstracts.]
If the transferred assets are readily obtainable elsewhere (such as Treasury Bonds or widely
traded corporate bonds), then a call option (regardless of size) will not disqualify sale treatment,
and certain forward repurchase agreements may not give the transferor effective
control. [30] The theory here is that if the assets are readily obtainable elsewhere, the transferee
can sell the transferred assets (thereby relinquishing the seller’s “effective” control),
and if the call option is exercised, the buyer can readily find suitable assets in sufficient
quantity to satisfy the call. This provision does not offer much practical utility for the securitization
of consumer or other types of loans (though some widely traded debt securities
are “readily obtainable”). It is unlikely that an SPE would be permitted to sell the transferred
assets and be able to buy substantially the same loans acceptable to the transferor
in the event the transferor exercises its call option.
It’s interesting (and to some, counterintuitive) that put options held by the transferee or
holders of its securities do not disqualify sale treatment (but be sure to check with legal
7

8
counsel, as put options complicate the “true sale” analysis). The FASB’s theory here is that
a put option is in the transferee’s control; therefore the seller has relinquished control, even
if only temporarily. For example, convertible ARMs could be securitized with a put back to
the transferor if the borrower converts. Short-term tranches could have a guaranteed final
maturity in the form of a put to achieve “liquid asset” treatment for thrifts or “money market”
treatment for certain classes of investors. In each of these cases, at the sale date, the
transferor would have to record as a liability the fair value of the put obligation. If it is not
practicable to estimate its fair value, no gain on sale can be recorded.
A very “deep in the money” put is the economic equivalent of a repurchase obligation. The
SEC staff has pointed out the inconsistency of sale treatment and deep in the money puts.
Also, asymmetrical principal distributions such as turbo features, sequential pay classes, controlled
amortization or bullet payments in revolving structures can be adopted in sale transactions.
However, provisions that both entitle and obligate the transferor to reacquire nonreadily
obtainable assets are considered forward commitments to repurchase and do not
qualify for sale treatment. These differ from a put or call option because an option is volitional.
If it is disadvantageous to the buyer to exercise its put rights, the buyer lets them
lapse and can sell the assets at a better price in the open market. In a forward, the buyer is
obligated to perform; it must return the assets. For example, consider 5/1 ARMs in which
the borrower’s interest rate periodically adjusts after the initial five-year fixed rate period.
If these loans were transferred for just the five-year period, sale accounting would not be
appropriate. However, a buyer put at the end of five years would be acceptable (subject to
meeting the other sale criteria).
MUST A QUALIFYING SPECIAL-PURPOSE ENTITY BE “BRAIN-DEAD”?
If it is not brain-dead, it must at least be on automatic pilot. A QSPE must meet both conditions
(a) and (b) below:
2
SECTION
a. It is a trust, corporation, or other legal vehicle whose activities are permanently limited to:
1] Holding title to the transferred assets.
2] Issuing beneficial interests in the form of debt or equity securities. These include rights
to receive all or portions of specified cash inflows, including senior and subordinated
rights to interest or principal inflows to be “passed through” (e.g., multiclass participation
certificates) or “paid through” (e.g., notes or bonds) and residual interests.
3] Collecting cash proceeds from assets held, reinvesting in eligible investments
pending distribution and perhaps servicing the assets held.
4] Distributing proceeds to the holders of its beneficial interests.
b. It has standing at law distinct from the transferor. If the transferor holds all of the beneficial
interests, the trust has no standing at law and is not distinct. Thus it is not a
QSPE, and such a transaction is neither a sale nor a financing. The true test here is
whether the transferor gives up the ability to unilaterally dissolve the trust and reclaim
the individual assets. [26] SPEs that issue debt or equity interests to parties unaffiliat-

ed with the transferor usually meet the condition of having standing at law distinct
from the transferor because the transferor may not dissolve the entity without any
involvement by the third-party holders of the beneficial interests.
Some say a QSPE is not allowed to think. As noted above, a QSPE may service its assets.
While these activities may require management involvement, they involve support and not
trading activities and, thus, are permitted.
A QSPE is also limited to holding only financial assets. Therefore, any SPE holding nonfinancial
assets, such as unguaranteed residual values in direct financing leases, would not be
considered a QSPE. A QSPE may temporarily hold nonfinancial assets as a result of foreclosing
on financial assets (e.g., repossessed autos).
FASB 125 does not address whether a QSPE is permitted to hold derivatives. However, the
FASB staff addressed this issue in the FASB 125 Q&A Implementation Guide (questions 25-
27). A QSPE may hold derivatives if they are entered into by the QSPE at the inception of
the QSPE or when the QSPE issues beneficial interests. Another key consideration: the
derivative position cannot cause the transfer to fail the sale conditions of FASB 125, including
the requirement that the assets are legally isolated and the requirement that the transferor
surrender effective control. Finally, the derivative position cannot have the potential
to cause the QSPE to fail any of the criteria established by EITF Topic D-66 (see page 19).
An example of a derivative entered into by an SPE is an interest rate swap. If the SPE has
fixed rate assets and issues variable rate beneficial interests, the entity may enter into a “pay
fixed/receive variable” interest rate swap with the transferor or a third party at the inception
of the transfer to provide protection to investors against changes in interest rates. Provided
the swap was entered into concurrently with the purchase of financial assets or the issuance
of beneficial interests, the swap would not preclude the entity from being a QSPE.
Determining whether the securitization meets the sale criteria
Derivatives entered into between the transferor or an affiliate and the securitization vehicle
require special scrutiny because they could cause a lawyer to conclude that legal isolation
is not met. While interest rate swaps, fixing an interest rate mismatch between the assets
and the beneficial interests are not uncommon, a total return swap may preclude counsel
from rendering an appropriate true sale opinion. 8
Some derivative strategies require active management (e.g. using futures and options to
hedge the prepayment risk of a mortgage portfolio). Again, such strategies warrant special
scrutiny. It is doubtful that all of the derivatives could be entered into only at inception or upon
issuance of beneficial interests. Also, because derivatives are rarely perfect hedges of the
8. Although their terms differ, some total return swaps result in an affiliate of the transferor retaining all of the risks inherent
in the assets. As a result, the beneficial interest holder’s return is predicated only on the credit worthiness of the
transferor’s affiliate rather than on the performance of the securitized assets.
9

10
exposure they are designed to manage, it may be difficult to discern whether the positions are
managed solely in an effort to reduce risk or, perhaps, with an eye to generating profits. The
latter motivation is inconsistent with the restrictions on QSPEs so-called “trading for gains.”
As noted above, activities of a QSPE include issuing beneficial interests. There is no requirement
that all of these interests be issued at the same time. Future issuances or rollover of
beneficial interests would not preclude an SPE from being considered qualifying if the future
issuances are permitted under the governing trust documents, the future issuances occur
automatically, and the issuer is not entitled to reacquire the assets.
DO QSPES GET CONSOLIDATED?
FASB 125 does not provide any guidance on consolidation of SPEs. The FASB had hoped to
issue a new accounting standard on consolidation simultaneously with FASB 125, but was
unable to do so. 9 The off-balance sheet goal of a securitization would be defeated if the
securitizer is required to consolidate the accounts of the SPE to which the assets are ultimately
transferred, particularly if the SPE has issued debt securities. For example, consider
the transaction in which you structure a securitization that clearly meets all three criteria
for a sale, using a qualifying wholly-owned SPE that issues debt and equity interests, and
then proceed to consolidate the SPE. The transferred assets re-emerge on the balance
sheet. Contrast this with simply accounting for the retained interests in the securitization
(in form, often equity interests in the SPE) as a residual financial asset.
Fortunately, the EITF addressed this issue. In Issue 96-20, they reached the following consensus.
If the SPE:
1] meets all of the conditions of paragraph 26 of FASB 125 to be a QSPE; (see page 8)
2] holds only financial assets such as receivables from credit cards, mortgage loans or
securities that represent a contractual right to cash (or another financial instrument)
from, or an ownership interest in, an entity that is unrelated to the transferor;
3] does not undertake a transaction (or a series of transactions) that has the effect of (a) converting
nonfinancial assets, for example, real estate or servicing assets, into a financial asset
or (b) recognizing a previously unrecognized financial asset, for example, an operating lease;
then the transferor has surrendered control over the financial assets, and consolidation
is not appropriate regardless of whether the SPE is wholly owned or whether it has any equity.
2
SECTION
9. The FASB has proposed a Statement on Consolidations Policy, which is scheduled to be finalized in the second quarter
of 2000. The current version does not provide much guidance on consolidation of securitization SPEs. It is possible
that, under this new standard, “sponsors” of non-majority owned SPEs will be deemed to “control” the SPE and therefore
be required to consolidate the financial statements of the SPE with the sponsor’s own financial statements. Given
the limited activities of SPEs and other features of securitizations, it is reasonable to expect that many sponsors will be
able to demonstrate that they do not “control” SPEs. However, this is a fact-intensive determination that will have to be
carried out individually for each SPE, and it is impossible to say at this time how the “control” test will be interpreted
in various circumstances. Stay tuned for further developments.

WHAT IF THE ISSUER IS NOT A QSPE?
If the securitization vehicle fails to meet QSPE criteria (for example, it buys and sells securities
for its portfolio of pledged collateral), the sponsor, creator or transferor needs to determine
whether it must consolidate the entity using the following accounting guidance:
• If the sponsor, creator, transferor or third party investor owns the majority of the equity and
voting rights, and the entity is significantly capitalized then the entity should be consolidated
by that majority owner pursuant to ARB 51 and FASB 94
• If the entity is nominally capitalized (see below), then regardless of who nominally owns
the majority of the equity and voting rights, the sponsor, creator or transferor needs to
look to the consolidation criteria of EITF Abstracts, Topic D-14, and by analogy, EITF 90-15,
96-16, 96-20 and 96-21 to determine whether the SPE should be consolidated.
When the securitization vehicle is not a QSPE, EITF Topic D-14 and related EITF topics require
an initial (and ongoing) substantive (e.g. 3%) residual equity capital investment, held by third
party investors who control the majority of the equity and voting rights. Securities in the form
of equity often have less investor appeal compared to debt securities. For example, internal policy
or external regulation may preclude many potential investors from investing in equity securities.
As a result, many deals such as CBOs have been structured with the substantive capital
investment taking the form of subordinated debt.
However, the SEC staff has said legal form is critical. A third party investment that takes the
form of debt, regardless of the degree of its subordination or its economic similarity to equity,
will not qualify for the “3% test”. The Chief Accountant of the SEC and members of his staff reiterated
this point in speeches during the closing months of 1999, asserting that they would
require consolidation of the non qualifying SPE by the sponsor in those circumstances.
Determining whether the securitization meets the sale criteria
IS IT POSSIBLE TO STRUCTURE DEBT-FOR-TAX AS A SALE FOR GAAP?
We find that the securitization term “debt-for-tax” means different things to different people.
In its most advanced state, the securitizer seeks to meet all of the following objectives,
not simply the first one:
1] The securities being issued are characterized as debt of the Issuer rather than equity in
an entity, in order to avoid “double taxation.”
2] The transaction is treated as a financing by the transferor for tax purposes. This is
accomplished by including the assets and debt of the Issuer in a consolidated tax
return of the transferor, which results in deferring an up-front tax on any economic gain
realized in the securitization. Note that in the case of mortgage loans, REMIC transactions
are, by definition, a sale for tax purposes to the extent the sponsor disposes of
the regular and/or residual interests.
11

12
3] Notes or Bonds rather than Pass-Through Certificates are issued so as to invite easier
participation and eligibility for certain categories of investors such as Employee
Retirement Income Security Act (ERISA) plans.
4] The transaction is treated as an “off-balance sheet” sale for accounting purposes with
recognition of any attendant gain and without consolidation of the Issuer into the financial
statements of the transferor.
To meet that accounting objective, we suggest you follow the following guidelines:
1] The issuer needs to be a QSPE (see page 8). Note that in a two-tier structure, the entity
that issues the debt (e.g., the owner trust) needs to be the QSPE. The “intermediate
SPEs” (e.g., the Depositor) are typically not considered QSPEs. As long as the “issuing
SPE” is a QSPE, the nature of the intermediate entities should not affect the accounting
treatment for consolidation purposes.
2] The legal form of the QSPE does not matter for accounting purposes so long as it has
distinct standing at law. It can be an owner trust, partnership, corporation, etc.
3] There is no minimum size requirement for the equity of the QSPE for accounting purposes,
but check with your tax advisors.
4] The equity of the QSPE can be wholly owned by the transferor.
5] The assets transferred to the QSPE must all be financial assets.
6] The transfer of assets to the QSPE must meet the sale accounting requirements of FASB 125.
The critical factor here is that the lawyers will be asked to give a “would” opinion on the
question of isolation of assets in the event of bankruptcy of the transferor or its affiliates.
7] Put options may be okay if the bankruptcy lawyers say they are okay (see item 6 above).
8] Call options are problematic. Generally, the Issuer and the tax lawyers want substantive
call provisions and the accountants and underwriters do not. The Chief Accountant of the
SEC announced that call options on the bonds should be viewed the same way as call
options on the transferred assets; that is, the use of such call options would be considered
inconsistent with the sale accounting requirements of FASB 125, [Topic D-63 of the EITF
Abstracts]. In practice, a “safe harbor” has emerged at the 10 percent of transferred assets
level to qualify as a cleanup call provided the transferor or an affiliate is the servicer and
holds the cleanup call.
2
SECTION
The fact that QSPEs are no longer consolidated for GAAP has somewhat reduced the tension
that often existed between accountants and tax professionals when trying to structure
a “debt-for-tax/sale-for-GAAP” deal. It has also allowed for the issuance of collateralized
debt securities by QSPEs rather than some form of hybrid debt/participation certificate. Tax
practitioners generally take into consideration the following factors in determining whether
a transaction should be treated as a financing, and some of the factors are given greater
weight than others:
1] A revolving period of at least one year or a partial reinvestment of principal collections
in newly originated collateral for at least three years;

2] Payment mismatch (e.g., monthly pay collateral vs. quarterly pay debt);
3] Use of excess spread to pay principal on debt so that the debt can be retired before the
collateral is repaid;
4] Existence and the size of the present value of the equity in the issuing entity;
5] Nomenclature used in the transaction (i.e., labeling the securities as bonds or notes);
6] Interest rate cap (i.e., a debt-like cap at an objective rate or an equity-like cap at the
weighted average rate of the loans);
7] Right of the Issuer to call the debt at a point significantly earlier than a typical cleanup
call (see previous warning for GAAP sale treatment);
8] Use of a floating rate index for interest on the debt different than the index on the
underlying loans.
CAN WAREHOUSE FUNDING ARRANGEMENTS BE OFF-BALANCE SHEET?
One ingredient for a successful securitization is adequate deal size – securitizing a pool of
assets that has reached critical mass. If the deal is sufficiently large, the costs of developing
the structure and paying advisors, underwriters, ongoing administrators and trustees
are typically more economical in relation to the amount of capital raised. Also, large deals
attract a larger pool of investors and enhance the “name recognition” of the securitizer.
Traditionally, a securitizer of longer-term assets accumulates (or warehouses) these assets
on its balance sheet. When the pool reaches critical mass, the loans are sold in a typical
term securitization. During the accumulation phase, the securitizer finances the cost of carrying
the assets with prearranged lines of credit, known as warehouse or repo lines.
Typically, the securitizer hedges the price risk of loans in the warehouse as they await sale.
The loans are often securitized near quarter-end to assure that the on-balance sheet shortterm
funding can be retired, so as not to violate debt covenants that might exist.
Determining whether the securitization meets the sale criteria
There are disadvantages to the traditional warehouse approach. Because so many securitizers
sell assets close to quarter-end, the supply concentration could widen securitization
spreads. Also, market participants fear that an unexpected, large disruption in the capital markets
could temporarily preclude securitizers from timely access to needed funds. Finally, if a
securitizer is unable to execute a securitization on schedule, equity analysts would likely
demand explanations for the delay and for the absence of securitization income that quarter.
An off-balance sheet warehouse securitization offers a partial solution to these problems.
But these structures—offered in a variety of flavors—need careful accounting scrutiny to
comply with the off-balance sheet criteria of FASB 125 and related EITF guidance while preserving
debt treatment for tax.
In an off-balance sheet warehouse, a commercial or investment bank typically purchases a
class of beneficial interest issued by a securitization vehicle created by the seller. Using the
proceeds from the sale of the beneficial interest, the vehicle acquires loans from the secu-
13

14
ritizer as they are originated. The beneficial interest takes the form of a variable funding
note, whose principal adjusts upward, to a ceiling, as the securitizer transfers additional
loans to the vehicle. The seller retains a beneficial interest that entitles it to all cash flows
on the loans not needed to service or credit enhance the variable funding note.
When the transferred assets have reached critical mass and market conditions are judged
appropriate, the holder of the variable funding note puts it back to the vehicle, forcing the
entity to dispose of the assets to raise cash to redeem the note.
Properly structured, puts such as these comply with the sale criteria of FASB 125 and do not
disqualify the entity from being a QSPE. Sometimes, the seller bids on the assets in a bona
fide auction and, if successful, reacquires the assets and sells them again in a term securitization.
10 See page 19 for a description and limitations on the powers of a QSPE under EITF D-66.
What triggers the investment bank’s desire to put its interest? Presumably, the investment
bank and the securitizer have ongoing discussions regarding the state of the securitization
markets, the securitizer’s preference for a term securitization, and the investment bank’s
desire to earn fees associated with underwriting the term deal. Also, most investment
banks do not have the appetite for long-term investments with the characteristics of the
variable funding note. All of these factors – plus a desire for an ongoing relationship with
the securitizer – suggest that the investment bank would look favorably upon a suggestion
to put their interests. The fact remains that there cannot be a contractual obligation or a
direct or indirect financial compulsion that effectively forces the investment bank to exercise
the put. Bottom line – the securitizer places significant trust in its investment banker in
order to achieve off-balance sheet accounting.
If the warehouse securitization structure complies with all of the off-balance sheet sale conditions
of FASB 125 and related EITF guidance, the securitizer recognizes a book gain or
loss on the transfer but typically not a tax gain or loss. Gain or loss is calculated conventionally,
but without anticipating any of the benefits that might arise in a subsequent term
securitization of the assets, and based solely on the terms of the warehouse arrangement.
2
SECTION
As a practical matter, one should be skeptical of any gain calculation that produces a gain
in excess of the gain that could have been obtained had the securitizer sold the loans outright
in a whole loan sale without any continuing involvement beyond conventional servicing.
Why? Fundamentally, the life of a warehouse securitization is much shorter compared
to a term transaction, but its actual duration is difficult to predict. This complicates
the estimate of the relative fair value of the retained interests. Also, a term securitization
often takes advantage of arbitrage opportunities, typically by using a multi-class structure
designed to satisfy the narrow appetites of different investor classes. Because the securitizer
cannot record this benefit until a term securitization takes place, any gain on a warehouse
deal would be relatively smaller.
10. Note that D-66 deals with a securitizer’s participation in an auction process. Included in this guidance is the observation
that a recurring pattern of reacquisitions can suggest the existence of a prohibited call option.

CAN I CONVERT LOANS TO SECURITIES ON MY BALANCE SHEET?
For liquidity purposes, state tax planning, capital requirements or other reasons, financial
institutions might wish to convert whole loans to one or more classes of securities at least
in the near term. Because no proceeds are raised, these transactions are neither a sale nor
a financing under FASB 125. At the time of this writing, the FASB is working on a Technical
Bulletin which concludes that if the conversion was accomplished through an SPE that is not
a QSPE, then the transferor should account for the transferred financial assets in its consolidated
financial statements in accordance with their form prior to the transfer because the
securities held and issued would be eliminated in the consolidated financial statements. On
the other hand, if a non-consolidated QSPE is used, the assets would be accounted for in
the transferor’s consolidated financial statements as debt securities with no gain or loss recognized
unless the securities are classified as trading. Stay tuned for further FASB Technical
Bulletin developments.
WHY DO THE ASSETS HAVE TO BE ISOLATED?
While the benefits of asset isolation are no doubt laudatory, why has the FASB incorporated
this notion as a condition for sale accounting? The Board explains its decision as follows:
Credit rating agencies and investors pay close attention to the possibility of bankruptcy
of the transferor, its affiliates or the special-purpose entity, even though the
possibility may seem unlikely, because those are major risks to them. If receivers
can reclaim securitized assets, investors will suffer a delay in payments due them,
and may be forced to attempt a pro rata settlement. Credit rating agencies and
investors commonly demand transaction structures to minimize those possibilities.
They also seek assurances from attorneys about whether entities can be
forced into receivership, what the powers of the receiver might be, and whether
the transaction structure would withstand receivers’ attempts to reach the securitized
assets in ways that would harm investors. Unsatisfactory structures or assurances
could result in credit ratings that are lower than those of the transferor’s liabilities,
and in lower prices for transferred assets. [118]
Determining whether the securitization meets the sale criteria
Many securitizations use two transfers to isolate transferred assets beyond the reach of the
transferor and its creditors:
STEP 1: The corporation transfers assets to a Special-Purpose Corporation (SPC) that, although
wholly owned, is designed so that the chance of the transferor, or its creditors, reclaiming
the assets is remote. The first transfer is designed to be judged a true sale at law, in
part because it does not provide credit or yield protection.
STEP 2: The SPC transfers the assets to a trust, with a sufficient increase in the credit and yield
protection on the second transfer, to merit the high credit rating sought by investors. The
second transfer may or may not be judged a true sale at law and, in theory, could be
reached by a bankruptcy trustee for the SPC. However, the SPC’s charter forbids it from
15

16
undertaking any other business or incurring any liabilities, so that there can be no creditors
(other than any arising from the securitization itself) to petition to place it in bankruptcy.
Accordingly, the SPC is designed to lessen the possibility that it would enter bankruptcy,
either by itself or as part of a bankruptcy of its parent. [57]
A one-tier structure with significant continuing involvement by the transferor might not satisfy
the isolation test. A trustee in bankruptcy of the transferor might find the transfer to not
be a true sale in such circumstances, and has substantial powers to alter amounts that
investors might receive.
Generally, the standard for isolation of assets would be met if it is concluded that:
1] The transfer from the originator to the subsidiary SPC constitutes a true sale;
2] The SPC, on one hand, and its affiliates that are not SPCs, on the other hand, would not
be substantively consolidated in the case of the bankruptcy of any such applicable affiliate;
and
3] The final transfer from the consolidated group is either a true sale or the transfer of a
first priority, perfected security interest in the transferred assets.
Do I always need a lawyer’s letter? (See page 17.)
Any company or subsidiary — regardless of location — that prepares financial statements
in accordance with U.S. GAAP must adequately isolate securitized assets (and meet the
other conditions of FASB 125) to achieve sale accounting. Whether assets have been isolated
will depend on an evaluation of laws in the jurisdiction governing the transaction. The
advice of counsel familiar with local laws is especially important.
DO BANKS HAVE TO ISOLATE THEIR ASSETS TO GET SALE TREATMENT?
2
Banks are not subject to the U.S. bankruptcy code. Right now, banks are operating in a kind
of GAAP limbo. FASB 125 indicates that the powers of the Federal Deposit Insurance
Corporation (FDIC), acting as a receiver for a failed financial institution, are in synch with
the FASB’s notion of legal isolation. But FASB 125 mischaracterized and underestimated the
agency’s real powers. While the proposed amendment to FASB 125 clears up the misunderstanding,
it does not revise the general criterion for legal isolation or make it any easier
to meet. A FASB staff announcement (EITF Abstracts, Topic D-67) currently lets banks satisfy
the legal isolation criterion by permitting them to rely on FASB 125 as originally written,
but only until the proposed amendment is effective.
In September 1999, the FDIC issued a proposed rule designed to help banks continue to
meet the GAAP requirements. The proposed rule states:
SECTION
The FDIC shall not, by exercise of its authority to disaffirm or repudiate contracts,
reclaim, recover or recharacterize as property of the institution…any financial asset

transferred by an insured depository institution in connection with a securitization or
participation, provided that such transfer meets all conditions for sale accounting
under generally accepted accounting principles, other than the legal isolation condition,
which is addressed by this section.
Lawyers will have to evaluate whether the FDIC’s proposed rule places them in a position to
issue a “would” opinion on whether the transferred assets would be beyond the reach of the
FDIC and the banks’ other creditors, even in the event that the bank was placed in receivership.
Banks do retain one advantage. Under the FDIC’s proposed rule, although the securitization
must be issued by an SPE, a two-tier structure (with an intermediate bankruptcy remote entity)
does not appear to be needed.
DO I ALWAYS NEED A LAWYER’S LETTER?
In late 1997, the American Institute of Certified Public Accountants issued an interpretation of
generally accepted auditing standards,The Use of Legal Interpretations as Evidential Matter
to Support Management’s Assertion That a Transfer of Financial Assets Has Met the Isolation
Criteria in Paragraph 9 (a) of Statement of Financial Accounting Standards No. 125.
The interpretation contains an extract of a legal opinion (for an entity that is subject to the
U.S. Bankruptcy Code), which provides persuasive evidence (in the absence of contradictory
evidence) to support management’s assertion that the transferred assets have been
isolated. In short, it is a true sale “would” opinion vs. a “should” or “more likely than not”
opinion. This represents the highest level of assurance counsel is able to provide on the
question of isolation. The example follows:
Determining whether the securitization meets the sale criteria
We believe [or it is our opinion] that in a properly presented and argued case, as a legal
matter, in the event the Seller were to become a Debtor, the transfer of the Financial
Assets from the Seller to the Purchaser would be considered to be a sale [or a true sale]
of the Financial Assets from the Seller to the Purchaser and not a loan and, accordingly,
the Financial Assets and the proceeds thereof transferred to the Purchaser by the Seller
in accordance with the Purchase Agreement would not be deemed to be property of the
Seller’s estate for purposes of [the relevant sections] of the U.S. Bankruptcy Code.
...Based upon the assumptions of fact and the discussion set forth above, and on a reasoned
analysis of analogous case law, we are of the opinion that in a properly presented
and argued case, as a legal matter, in a proceeding under the U.S. Bankruptcy
Code, in which the Seller is a Debtor, a court would not grant an order consolidating
the assets and liabilities of the Purchaser with those of the Seller in a case involving the
insolvency of the Seller under the doctrine of substantive consolidation. [If an affiliate
of the Seller has also entered into transactions with the Purchaser, the opinion should
address that.]
17

18
The previous example deals with a one-step transfer of financial assets. In a two-step transfer,
a lawyer’s opinion should also address the second transfer (from the wholly-owned
bankruptcy remote subsidiary to the securitization vehicle that issues beneficial interests to
investors). In most securitizations that feature credit enhancement (for example, the whollyowned
bankruptcy remote subsidiary retains a subordinated interest in the securitization
vehicle), the lawyer’s letter usually cannot conclude that the second transfer is a true sale.
Instead, the attorney usually concludes that this transfer would either be a true sale or a
secured financing and that is acceptable.
Other issues covered in the auditing interpretation:
2
QUESTIONS
What should the auditor consider in
determining whether to use a lawyer
to obtain persuasive evidence to support
management’s assertion that a
transfer of assets meets the isolation
criterion of FASB 125?
If the auditor determines that the use of
a lawyer is required, what should he or
she consider in assessing the adequacy
of the legal opinion?
Are legal opinions that restrict the use
of the opinion to the client or to third
parties other than the auditor acceptable
audit evidence?
If the auditor determines that it is
appropriate to use the work of a
lawyer, and either the resulting legal
response does not provide persuasive
evidence...or the lawyer does not grant
permission for the auditor to use a
legal opinion that is restricted..., what
other steps might an auditor consider?
KEY POINTS
• Use of a lawyer may not be necessary when there is a routine transfer
of financial assets without continuing involvement by the seller
(e.g., full or limited recourse, servicing, other retained interests in
the transferred assets or an equity interest in the transferee).
• Use of a lawyer usually is necessary if, in the auditor’s judgment,
the transfer involves complex legal structures, continuing seller
involvement or other legal issues that make it difficult to determine
whether the isolation criterion is met.
• The auditor should evaluate the need for updates to a legal opinion
if transfers occur over an extended period of time or if management
asserts that a new transaction is the same as a prior structure.
• The lawyer may be a client’s internal or external attorney who is
knowledgeable about relevant sections of the law.
• The auditor should consider whether the lawyer has experience
with relevant matters, such as knowledge of the U.S. Bankruptcy
Code and other applicable foreign or domestic laws and knowledge
of the transaction.
• A lawyer’s conclusion about hypothetical transactions generally
would not provide persuasive evidence because it may be neither
relevant to the actual transaction nor contemplate all of the facts
and circumstances or the provisions in the agreements of the actual
transaction.
No. The auditor should request that the client obtain the lawyer’s
written permission for the auditor to use the opinion. Language to
the effect that the auditors are authorized to use but not rely on the
lawyer’s letter is not acceptable audit evidence.
• Because isolation is assessed primarily from a legal perspective,
the auditor usually will not be able to obtain persuasive evidence in
a form other than a legal opinion.
• In the absence of persuasive evidence, sales accounting is not in
conformity with GAAP, and the auditor should consider the need to
modify the auditor’s report on the financial statements.
SECTION

The interpretion does not currently apply to securitizations by FDIC-insured institutions, but
Do banks have to isolate their assets to get sale treatment? (See page 16.)
CAN A QSPE EVER SELL ITS ASSETS?
The FASB staff provided guidance on the powers of a QSPE in an announcement at the
January 1998 EITF meeting (documented in Topic D-66 of the EITF Abstracts). Topic D-66
addresses the effect of an SPE’s powers to sell, exchange, repledge or distribute transferred
financial assets (collectively these are referred to below as the “powers” of a QSPE).
Topic D-66 allows an SPE to exercise a power to sell, exchange, repledge or distribute transferred
financial assets in response to a cleanup call or if all of four stipulated conditions
exist. As will be seen, the conditions prevent a securitizer from transferring “off balance
sheet” all or a portion of its managed investment or trading portfolio. The conditions also
block an end run around FASB 125’s prohibition on achieving sale accounting when the seller
has effective control over the transferred assets.
The four conditions follow and the Topic D-66 examples are included in the accompanying table.
1] The powers and the conditions or events that permit them to be exercised are specified in and limited
permanently by the legal documents that (a) establish the SPE or (b) initially create the beneficial
interests in the transferred assets that are subject to the powers.
2] The powers do not result in the transferor or its affiliates maintaining effective control over the
transferred assets or over the sale of those assets.
3] The primary objective of the powers is not to realize a gain in the fair value of the transferred
assets above their fair value at the time they were transferred to the SPE. Also, those powers do
not permit the transferor, its affiliates or the SPE the discretion to sell transferred assets to maximize
the return to all or some of the beneficial interest holders. This condition does not preclude
beneficial interest holders other than the transferor and its affiliates from having the ability to put
their beneficial interests back to the SPE and, thereby, trigger the sale or distribution of assets.
4] The powers do not permit active or frequent selling and buying of assets.
Determining whether the securitization meets the sale criteria
Under the FASB staff’s guidance, an SPE is not qualifying if it can sell instruments in which
cash reserves are reinvested for purposes of realizing a gain or otherwise maximizing the
return to some portion of the beneficial interest holders. Also not qualifying is an SPE that
is empowered to actively manage its temporarily invested cash reserves by selling and
reinvesting. Note that the staff’s interpretation does not limit the type of instruments in
which to reinvest temporary cash.
19

20
EXAMPLE: An SPE has cash balances that will not be distributed to beneficial interest holders for 200
days. The documents that establish the SPE give it the discretion, in these circumstances, to choose
between investing in commercial paper obligations that mature in either 90 or 180 days. This discretion does
not preclude the SPE from being qualifying. If, in these circumstances, the SPE also has the discretion to
invest in 360-day commercial paper with the intent to sell it in 200 days, the SPE is not qualifying.
Limited powers of a QSPE specified in the original governing documents
Powers that enable the SPE to sell its assets or put them back to the transferor
EXAMPLES CONSISTENT WITH QSPE STATUS
The SPE has the power to either (1)”put” the transferred
assets back to the transferor or (2) sell those assets in
response to (a) a default by the obligor, (b) a major thirdparty
rating agency downgrade of the transferred assets
or the underlying obligor to a rating below a specified
minimum rating, or (c) a decline in the fair value of the
transferred assets to a value significantly less than their
fair value at the time they were transferred to the SPE.
The SPE has the power to sell transferred assets (or to
“put” transferred assets to the servicer, to a third party
or back to the transferor) in response to a failure by
the transferor to properly service transferred assets that
could result in the loss of a substantial third-party
credit guaranty.
EXAMPLES INCONSISTENT WITH QSPE STATUS
The transferor has the power, either directly or indirectly,
to trigger a condition that enables an SPE to
sell the transferred assets (unless the triggering of
the condition would have a significant adverse consequence
to the transferor).
The SPE is required to return transferred assets back
to the transferor upon the occurrence of an event
that at the time of the initial transfer is probable to
occur (unless that transfer back would result in significant
adverse consequences to the transferor).
The SPE has the power to sell transferred assets in
response to a transferor’s decision to exit a market
or a particular activity.
The SPE has the power to sell transferred assets in
response to the transferor violating a nonsubstantive
contractual provision.
The beneficial interest holders in an SPE other than the
transferor may “put” their beneficial interests in the transferred
assets back to the SPE in exchange for (1) a full or
partial distribution of those assets, (2) cash (which may
require that the SPE sell those assets to the transferor or a
third party or issue beneficial interests to comply with the
put), or (3) new beneficial interests in those assets.
The SPE is obligated to sell transferred assets under
an option contract written by the SPE that entitles
parties other than the third-party beneficial interest
holders to “call” those assets and, under that
arrangement, permits the SPE to trigger a sale and
effectively recognize an appreciation in the fair
value of the transferred assets.
Auction sales
2
SECTION
The SPE’s original legal documents schedule a sale or an
auction of the transferred assets at the end of the life of
either the SPE or the beneficial interests in the transferred
assets; the transferor is precluded from bidding an
amount above fair value for the transferred assets, and
the sale or auction includes obtaining bona fide offers
from participants other than the transferor. However, a
pattern of the transferor obtaining transferred assets
through scheduled sales or auctions would suggest that it
is bidding amounts greater than fair value and, therefore,
maintaining effective control over the transferred assets.
The SPE’s original legal documents schedule a sale
or an auction of the transferred assets at the end of
the life of either the SPE or the beneficial interests
in the transferred assets, and the transferor (1) is
not precluded from bidding an amount higher than
fair value and (2) retains the residual interest in an
SPE, entitling it to receive all of the resulting gain
from the sale of transferred assets.

WHAT IF THE TRANSFER DOES NOT QUALIFY AS A SALE?
If the transfer does not qualify as a sale, the proceeds raised (other than retained beneficial
interests) will be accounted for as a secured borrowing, with no gain or loss recognized, and
the assets or securities will remain on the balance sheet. [12] Can I Elect Not to Recognize
Gain on Sale? (See page 25.)
Even accounting for a securitization as a financing requires the use of many subjective judgments
and estimates and could still cause volatility in earnings due to the usual factors of
prepayments and credit losses. After all, the company still effectively owns a residual even
though you cannot find it on the balance sheet. It is the excess of the securitized assets over
the associated debt. Different accounting treatments will apply from origination through
securitization and continue through maturity. Some of these differences are listed below:
a] In the financing scenario, the decision on what origination costs should be appropriately
deferred under FASB 91 rather than expensed takes on added significance in the
first year income statement, since these costs will remain deferred (amortized over the
life of the loan) rather than effectively reversed within a short time frame in a gain-onsale
calculation. The pace of amortization will be affected by prepayments and prepayment
estimates. On the other hand, the amount of points or origination fees and premiums
paid to purchase loans takes on less first year income statement significance
since they will be spread over a long period of time rather than effectively recognized
almost immediately in a gain on sale calculation.
b] When mortgage loans are originated or acquired with the intent to securitize as a
financing, then the loans generally will be classified as held for long-term investment
and will not be subject to a FASB 65 lower of cost or market (LOCOM) adjustment (e.g.,
from rising interest rates) during the accumulation period. A company might want to
reconsider its hedging policies during that period because the “income statement risk”
of a LOCOM adjustment or a lower gain on sale (e.g., if spreads widen) is mitigated.
But before revising hedging strategies, remember that the economic risk associated
with volatile interest rates preceding a term securitization is present regardless of the
accounting treatment.
c] If loans are securitized, and the securitizer retains all of the resulting securities and classifies
them as debt securities held to maturity under FASB 115, the securitizer does not
have to recognize a separate servicing asset. That is, the servicing asset can remain
embodied in the carrying value of the debt securities. If a servicing asset is created, it
will be subject to LOCOM accounting under FASB 125.
d] Underwriting fees and deal costs of issuance will be deferred and amortized over the
life of the bonds, and the pace of amortization will be affected by prepayments.
Determining whether the securitization meets the sale criteria
21

22
e] Provisions for credit losses will be made periodically under FASB 5, rather than initially
estimating all credit losses over the entire life of the loans transferred and providing
for them in the gain on sale calculation.
f] Original Issue Discount (OID) on bond classes will be amortized as additional interest
expense and the pace of amortization will be affected by prepayments. Also, in a deal
with maturity tranching, especially in a steep yield curve, significant amounts of “phantom”
GAAP income could result.
Assume, for instance, that four sequential pay tranches are issued at yields of 7%, 8%,
9%, and 10%, respectively and backed by a pool of newly-originated 10% loans. An
overall yield-to-maturity on the assets is calculated and used for FASB 91 purposes, but
interest expense on the bonds is calculated based on the yield to maturity of each outstanding
bond. The result is that the net interest margin reported in the earlier years
will exceed the net interest margin reported in the later years. Observe that, in this
example, there would be no income reported during the years in which only the last
class is outstanding. A more conservative answer, but perhaps not GAAP, would result
if the four bond classes were treated as a single large bond class, with a single weighted
average yield to maturity used to record the interest cost.
g] In Real Estate Mortgage Investment Conduit (REMIC) deals, which by definition are a
sale for tax purposes to the extent that the regular and/or residual interests are disposed
of, taxes will still have to be paid on any up-front tax gain, and a deferred tax asset will
be created for taxable income recognized before book income. When a company is willing
to account for its transactions as on-balance sheet financings, it can take advantage
of certain features of the FASIT legislation that would have been in conflict with sale
accounting treatment. In particular, the liberal substitution and permitted withdrawals of
assets when overcollateralized, and the ability to liquidate a class of securities and to
hedge certain risks (all permitted for FASITs), can be used to give an Issuer significantly
more flexibility than is available with REMIC structures. This does nothing, however,
to mitigate the showstopper in FASITs – the up front “toll charge” tax on an artificially
calculated gain.
2
SECTION

AND IF IT DOES QUALIFY AS A SALE?
“Gain on sale” accounting (as it is sometimes described in practice) or loss on sale is not
elective. It is inappropriate for the transferor to defer any portion of a resulting gain or loss.
See discussion below if it is not practicable to estimate the fair value of assets obtained or
liabilities incurred.
If the transfer qualifies as a sale, then:
1] Allocate the previous book carrying amount (net of loss reserves, if any) between the
assets sold and the retained interests, if any, based on their relative fair values on the
date of transfer. Allocation effectively defers a portion of the profit or loss — the
amount attributable to the portion(s) of the financial asset retained.
2] Adjust the net cash proceeds received in the exchange by recording, on the balance sheet,
the fair value of any guarantees, recourse obligations or derivatives such as put options written,
forward commitments, interest rate or foreign currency swaps. See FASB 133,
Accounting for Derivative Instruments and Hedging Activities, regarding the continuing
accounting for derivatives.
3] Recognize gain or loss only on the assets sold.
4] Continue to carry on the balance sheet (initially at its allocated book value [see step 1])
any retained interest in the transferred assets, including a servicing asset, beneficial
debt or equity instruments in the SPE or retained undivided interests. [10,11]
There is no provision that the amount of gain recognized on a partial sale cannot exceed
the gain that would be recognized if the entire asset was sold. The FASB indicated that
imposing such a limitation would have, among other things, resulted in ignoring the
added value (i.e., arbitrage) that many believe is created when assets are divided into
their several parts. [214]
Determining whether the securitization meets the sale criteria
23

QUESTIONS
RELATED TO DETERMINING GAIN
or
LOSS
on
SALE

CAN I ELECT NOT TO RECOGNIZE GAIN ON SALE?
More and more, securitizers are announcing that they will discontinue the use of “gain on
sale” accounting. This is in reaction to the:
• unwanted volatility in earnings that goes hand in hand with the timing of securitization
transactions
• vocal criticism (from equity analysts, in particular) that characterizes this accounting
as “front-ending” income
• rating agencies adding the securitization back to the balance sheet when considering
capital adequacy.
The following discussion covers some of the accounting issues that a company should consider
before making a switch.
1] The FASB and SEC staffs (EITF D-69) have determined that gain (or loss) on sale accounting
is not elective in a securitization that is accounted for as a sale. In other words, prepayment,
loss or discount rate assumptions may not be tailored so as to force a zero gain.
2] In order to report zero up-front gain, the securitization must therefore be structured as a
financing rather than a sale in virtually every case. However, one technical exception exists
in the following structure and fact pattern:
Questions related to determining gain or loss on sale
Assume that the securitizer issues a limited guarantee as credit enhancement for some or
all of the bonds. 11 Paragraph 45 of FASB 125 indicates that, “if it is not practicable to estimate
the fair value of a liability,” then the unknown liability should be recorded as the greater of:
(1) the sum of the known assets less the fair value of the known liabilities—i.e.,
“plug” the amount that results in no gain or loss; (Paragraph 46 [Case No. 2] in
FASB 125 illustrates that accounting) or,
(2) the FASB 5 liability (which may be zero).
As a practical matter, little guidance exists as to when “it is not practicable to estimate the fair
value of liabilities,” and a frequent securitizer would likely resist having to disclose an inability
to evaluate the creditworthiness of the pool. Moreover, FASB 125 does not give guidance
on the subsequent accounting under this option leaving any number of unresolved questions.
For example, is income not to be recognized at all until it becomes practicable to estimate
the fair value of the liability? And is income then to be recognized in one lump sum?
If it is not practicable to estimate the fair value of an asset (such as a residual interest), FASB
125 calls for the asset to be recorded at no value. Adherence to this accounting will usually
result in a loss on sale (even in par executions) after recognizing the out-of-pocket costs of the
securitization and the premiums paid to acquire loans or costs incurred to originate them.
11. In this booklet, the term “bonds” also includes pass-through certificates. Both are considered “beneficial interests”
in an SPE in FASB 125 parlance.
25

26
3] In circumstances other than the above, then, debt-for-GAAP seems to be the only practical
structure. Management usually has a strong objection to this financing treatment,
due to the resulting ballooning of the balance sheet and the negative implications that
this accounting has on debt/equity ratios, return on assets, debt covenant compliance,
etc. It should be borne in mind, however, that the balance sheet does not balloon further
if all cash securitization proceeds are used to repay on-balance-sheet warehouse
funding or other debt. On the other hand, the typical pattern of a frequent securitizer
today is to keep on-balance-sheet warehouse funding to a minimum as of quarterly
balance sheet dates and to employ sale accounting as the means used to shrink the
balance sheet debt.
4] Before issuing FASB 125, the FASB considered, but rejected, the UK approach of a
“linked presentation,” in which the pledged assets remain on the balance sheet, but the
sales proceeds (non-recourse collateralized debt) are reported as a deduction from the
pledged assets rather than as a liability, and no gain or loss is recognized. We think it
is time for the FASB to reconsider that approach as a means to resolve many of the
thorny conceptual dilemmas that they are struggling with.
5] The most common way of intentionally achieving debt-for-GAAP is by inserting a call
option that is not just a cleanup call. While no quantitative guidance exists on the maximum
size of a cleanup call, 10% of the transferred assets has always been the norm.
FASB 125 provides for a not too user-friendly definition of a cleanup call as occurring
“when the amount of outstanding assets falls to a level at which the cost of servicing
those assets becomes burdensome.” The FASB considered, but rejected, the suggestion
that a transaction with (for example) a 30% call should be accounted for as a 70%
sale and a 30% financing.
6] Investors sometimes object to buying or paying full value for a bond (particularly a
fixed-rate bond) subject to a significant call provision. This could perhaps be mitigated
by setting the exercise price for the call at a premium, which should not affect the financing
vs. sale determination under FASB 125 (unless the call is so far out of the money as
to lack substance).
7] Other terms or conditions that would cause a securitization to be accounted for as
debt-for-GAAP include:
3
SECTION
• A call of any size (even 1%) if the transferor is not also the servicer. Oddly enough,
this is what the FASB 125 Q&A Implementation Guide states. This conclusion, however,
is slated to be overturned in the planned FASB 125 amendment.
• Use of a wholly-owned SPE as the issuer of secured debt, if the SPE has been
granted certain powers to sell its assets or enter into derivative contracts that disqualify
it from being a QSPE under EITF D-66. (Such a grant would cause the SPE

to be consolidated pursuant to EITF 96-20.) Nothing has to last forever. If you later
decide to sell at least one-half of the residual (i.e. the SPE equity), and the outside
investors have made more than a nominal investment, you can deconsolidate at
that time and recognize gain or loss.
• Some unusual structural nuance that precludes counsel from issuing a “would”
opinion, allowing only a true-sale “should” opinion.
•Transferring non-financial assets to the issuing SPE in addition to financial assets.
• Imposing restrictions on the investors’ right to pledge or exchange their securities.
8] Turning back to calls: the first decision that must be made is whether the call option is
on the transferred assets or on the issued bonds. Either way, the SEC staff (EITF D-63)
has said that the transfer must be accounted for as a secured borrowing.
9] There is some question as to whether the pledged assets in a securitization accounted
for as a financing should be classified as loans or as securities. Paragraph 10 of FASB
125 says: “Upon completion of any transfer of financial assets,” [author’s interpretation:
whether or not it satisfies the conditions to be accounted for as a sale], “the transferor
shall: (a) continue to carry in its statement of financial position any retained interest
in the transferred assets, including, if applicable, servicing assets, beneficial interests
in assets transferred to a QSPE in a securitization, and retained undivided interests
and (b) allocate the previous carrying amount between the assets sold, if any, and the
retained interests, if any, based on their relative fair values at the date of transfer.” The
term “transfer” is defined in paragraph 243 to include “putting it into a securitization
trust” or “posting it as collateral.” On the other hand, paragraph 12 goes on to say, “If a
transfer of financial assets in exchange for cash…does not meet the criteria for a
sale…the transferor and transferee shall account for the transfer as a secured borrowing
with pledge of collateral.”
Questions related to determining gain or loss on sale
• If the pledged assets are treated as loans (their previous treatment), then they
would likely be considered loans held for long-term investment and not loans
held for sale. Thus there would be no FASB 65 LOCOM requirement, although valuation
allowances for credit losses would be required.
• If the pledged assets are treated as securities, then FASB 115 applies, and a decision
as to held-to-maturity (HTM), trading, or available-for-sale (AFS) is required.
• If classified as AFS, the asset side would be marked to market (affecting equity
and comprehensive income), but there is no GAAP guidance concerning marking
the corresponding liability side.
•The risk-based capital requirement for financial institutions might be different if
the assets were classified as securities rather than loans.
27

28
•There should be some other balance sheet caption to distinguish these pledged
assets from the loan or investment portfolio—for instance, “Securitized assets
subject to repurchase option.”
10] In comparing pro forma projected results of weaning off of gain-on-sale accounting,
don’t forget the income from the accretion of yield (at the discount rate) on the residual
interests retained in the sale accounting scenario.
11] The FASB has proposed extensive new disclosures relating to securitizations, including
the number and volume of transactions, cash inflows (outflows) with the securitization
trusts, disclosure of assumptions, and stress tests or sensitivity analyses of the
value of the retained interests. These disclosures will not apply to securitizations
accounted for as secured borrowings. Some companies provide supplemental information
showing key financial statement components on a pro forma basis as if their
off-balance sheet securitizations were on-balance sheet. The FASB considered, but
rejected, this type of presentation as being a required part of the new disclosures.
WHAT IF I CAN’T REASONABLY ESTIMATE FAIR VALUE?
In the event that it is not practicable to estimate the fair value of a retained asset, you must
value it at zero. Valuing a retained interest at zero will often result in recognizing a loss on sale
after considering transaction costs and any premium the transferor paid to acquire the assets
or capitalized costs the transferor incurred to originate the asset. In the event that it is not practicable
to estimate the fair value of any liability, you will not be able to recognize any gain on
sale. You may be required to record a loss if a liability under FASB 5 and FASB Interpretation
14 (Reasonable Estimation of the Amount of a Loss) would be recognized. [45]
When a securitizer concludes that it is not practicable to estimate fair values, FASB 125
requires footnote disclosure describing the related items and the reasons why it is not
practicable to estimate their fair value. Practicable means that an estimate of fair value
cannot be made without incurring excessive costs. It is a dynamic concept. What is practicable
for one entity might not be for another; what is not practicable in one year might
be in another. [211]
HOW IS GAIN OR LOSS DETERMINED IN A REVOLVING STRUCTURE?
3
Gain or loss recognition for receivables such as credit card balances, trade receivables or
dealer floor plan loans sold to a revolving securitization trust is limited to receivables that
exist and have been sold. Recognition of servicing assets is also limited to the servicing for
the receivables that exist and have been sold. [52] FASB 125 requires an allocation of the
SECTION

carrying amount of the receivables transferred to the SPE, between the sold interests and
the retained interests (based on relative fair value) be performed. See credit card example
on page 31.
A revolving securitization involves a large initial transfer of balances generally accounted for
as a sale; ongoing, smaller subsequent months’ transfers funded with collections of principal
from the previously sold balances (we like to call them “transferettes”) are each treated as
separate sales of new balances with the attendant gain or loss calculation. The record-keeping
burden necessary to comply with these techniques is quite onerous, particularly for master
trusts. Paragraph 46 of FASB 125 shows an example where the seller finds it impracticable
to estimate the fair value of the servicing contract, although it is confident that servicing
revenues will be more than adequate compensation for performing the servicing.
The implicit forward contract to sell new receivables during a revolving period, which may
become valuable or onerous as interest rates and other market conditions change, is to be
recognized at its fair value at the time of sale. Its value at inception will be zero if entered
into at the market rate. FASB 125 does not require securitizers to mark the forward to fair
value in accounting periods following the securitization. Also forwards in revolving deals
usually do not meet the definition of a derivative in FASB 133, Accounting for Derivatives,
and thus are not covered by FASB 133’s mark-to-market requirement.
Questions related to determining gain or loss on sale
29

30
How about an example of a gain on sale worksheet or template?
Assumptions (all amounts are hypothetical and the relationships between amounts do not purport to be representative of actual
transactions):
• Aggregate principal amount of pool $ 100,000,000
• Net carrying amount (principal amount + accrued interest + $ 99,000,000
purchase premiums + deferred origination costs -
deferred origination fees - purchase discount - loss reserves)
• Deal structure:
PRINCIPAL AMOUNT PRICE FAIR VALUE*
Class A $ 96,000,000 100 $ 96,000,000
Class B 4,000,000 95 3,800,000
Class IO 1,500,000
Class R 1,000,000
*Including accrued interest
TOTAL $ 100,000,000 $ 102,300,000
• Class IO and R are retained by the seller
• Servicing value: $ 700,000
• Up-front transaction costs (underwriting, legal,
accounting, rating agency, printing, etc.) $ 1,000,000
Basis allocation of carrying value:
% OF TOTAL ($99MM X%) ALLOCATED
COMPONENT FAIR VALUE FAIR VALUE CARRYING AMOUNT SOLD RETAINED
Servicing $ 700,000 .68% $ 673,200 $ 673,200
Class A 96,000,000 93.20 92,268,000 $ 92,268,000
Class B 3,800,000 3.69 3,653,100 3,653,100
Class IO 1,500,000 1.46 1,445,400 1,445,400
Class R 1,000,000 .97 960,300 960,300
TOTAL $ 103,000,000 100.00% $ 99,000,000 $ 95,921,100 $ 3,078,900
Net proceeds (with accrued interest, after $1 million transaction costs) $ 98,800,000
Pre-tax gain $ 2,878,900
Journal entries:
DEBIT
CREDIT
(1) Cash $ 98,800,000
Servicing asset 673,200
Class IO 1,445,400
Class R 960,300
Net carrying value of loans $ 99,000,000
Pre-tax gain on sale 2,878,900
(2) Class IO $ 54,600
Class R 39,700
Other comprehensive income (earnings, if trading) $ 94,300
3
In the second journal entry, the allocated carrying amounts of Class IO and Class R are adjusted upward to their fair values
because they are required to be classified as either available for sale or trading securities. [39] Note the following: 1) a similar
adjustment is not made for the servicing asset; and 2) a “haircut” on the amount of gain recognized applies when the Class
IO and Class R are classified as available for sale and not trading.
SECTION

How about a credit card example?
Assumptions (all amounts are hypothetical and the relationships between amounts do not purport to be representative of actual
transactions):
• Aggregate principal amount of pool $ 650,000,000
• Carrying amount, net of loss reserves $ 637,000,000
• Servicing value $ 5,000,000
• Value of fixed-price forward contract for future sales 0
• Up-front transaction costs $ 4,000,000
• Losses are reimbursed from excess interest spread account
• Deal structure:
PRINCIPAL AMOUNT PRICE FAIR VALUE
Class A $ 500,000,000 100 $ 500,000,000
Class B 25,000,000 100 25,000,000
Seller’s certificate 125,000,000 125,000,000
IO strip* 10,000,000
Servicing 5,000,000
TOTAL $ 650,000,000 $ 665,000,000
Basis allocation of carrying value:
% OF TOTAL ($637MM X%) ALLOCATED
COMPONENT FAIR VALUE FAIR VALUE CARRYING AMOUNT SOLD RETAINED
Class A $ 500,000,000 75.19% $ 478,960,300 $ 478,960,300
Class B 25,000,000 3.76 23,951,200 23,951,200
Seller’s certificate 125,000,000 18.80 119,756,000 $ 119,756,000
IO strip* 10,000,000 1.50 9,555,000 9,555,000
Servicing 5,000,000 .75 4,777,500 4,777,500
Questions related to determining gain or loss on sale
TOTAL $ 665,000,000 100.00 $ 637,000,000 $ 502,911,500 $ 134,088,500
Proceeds net of $1 million allocated transaction costs $ 524,000,000
(assumes 25% allocation to the initial sale)
Pre-tax gain $21,088,500
Journal entries:
DEBIT
CREDIT
(1) Cash $ 521,000,000
IO strip 9,555,000
Servicing asset 4,777,500
Seller’s certificate 119,756,000**
Deferred transaction costs 3,000,000
Net carrying value of loans $ 637,000,000
Pre-tax gain on sale 21,088,500
(2) IO strip $ 445,000
Equity (other comprehensive income) $ 445,000
* In determining the fair value of the IO strip, the seller would consider the yield on the receivables, charge-off rates, average
life of the transferred balances and the subordination of the IO flows in a spread account.
** Note that in the above example, the allocated carrying amount of the seller’s certificate is less than its principal balance.
FASB 125 does not provide any guidance on how such difference should be amortized. Presumably, it should be amortized as
additional yield over the average life of the retained balances.
Each month during the revolving period, the investor’s share of principal collections would be
used to purchase new receivable balances (“transferettes”), and an analysis similar to the above
would be made with a new gain or loss recorded. The record keeping burden to comply with
these techniques is onerous, particularly for master trusts.
31

32
IS FAIR VALUE IN THE EYES OF THE “B-HOLDER”?
Neither FASB 125 or the exposure draft of the proposed amendment introduce any new
accounting definition of fair value. The fair value of an asset or liability is defined as the
amount at which it could be bought or sold (or settled), in a current transaction between willing
parties, other than in a forced or liquidation sale. Quoted market prices in active markets
are the best evidence of fair value and should be used as the basis for the measurement,
whenever available. [42] If quoted market prices are not available, the estimate of fair value
should be based on the best information available. The estimate of fair value should consider
prices for similar instruments and the results of valuation techniques, such as the present
value of the estimated future cash flows using a discount rate commensurate with the risks
involved, option-pricing models, Option-Adjusted Spread (OAS) and matrix pricing. [43]
It would be unusual for a securitizer to find quoted market prices for most financial components
arising in a securitization — complicating the measurement process and requiring
estimation techniques. FASB 125 discusses these situations as follows:
•The underlying assumptions about interest rates, default rates, prepayment rates
and volatility should reflect what market participants would use.
• Estimates of expected future cash flows should be based on reasonable and supportable
assumptions and projections.
• All available evidence should be considered, and the weight given to the evidence
should be commensurate with the extent to which the evidence can be verified
objectively.
• If a range is estimated for either the amount or timing of possible cash flows, the
likelihood of all possible outcomes should be considered in determining the best
estimate of anticipated cash flows. [44]
In recent years, several public companies announced losses resulting from downward
adjustments to previously recorded retained interests in securitizations. The adjustments
often stemmed from securitized mortgage assets that prepaid more quickly than the sellers’
original estimates. The losses also led equity analysts to increasingly question the “quality
of earnings” of many securitizers. The analysts pointed out that FASB 125 gains are, for the
most part, non-cash; instead, the gains usually result from recording assets that represent
an estimate of the present value of anticipated cash flows.
3
In response, some securitizers indicated that they would utilize more conservative assumptions
when calculating the gain on securitizations. More conservative assumptions mitigate
or eliminate subsequent downward adjustments if adverse market developments occur.
SECTION
Also, in at least one well-publicized case, it was not clear that the securitizer would consistently
apply assumptions. That is, it appeared that the securitizer might use more conservative
assumptions for newly securitized assets but would not use similar assumptions

when estimating the fair value of retained interests in previously securitized assets.
Different assumptions should be used only when warranted by the facts and circumstances
of the specific assets securitized. For example, a securitizer is justified in making different
estimates for loans with substantively different terms or economic characteristics.
These developments prompted the SEC staff to make an announcement at the March 1998
EITF meeting, codified as Topic D-69 in the EITF Abstracts. Key points contained in the
announcement are as follows:
1] Recognition of gains or losses on the sale of financial assets is not elective.
2] In estimating the fair value of retained and new interests, the assumptions used in
those valuations must be consistent with market conditions. Using assumptions that
are not consistent with current market conditions in order to ascribe intentionally low
or high values to new or retained interests is not appropriate.
3] Assumptions and methodologies used in estimating the fair value of similar instruments
should be consistent. It would be inappropriate to use significantly different values
or assumptions for newly created retained interests that are similar to existing
retained interests.
Questions related to determining gain or loss on sale
4] Significant assumptions used in estimating the fair value of retained and new interests
at the balance sheet date should be disclosed. Significant assumptions generally
include quantitative amounts or rates of default, prepayment and interest.
The FASB proposed amendments to FASB 125 will require securitizers to provide disclosures
well beyond the above list for transactions accounted for as sales, but not those
accounted for as borrowings. See section 4 on page 45 for an illustration of the FASB’s proposed
disclosures. The Exposure Draft encourages early adoption of the disclosure requirements
of a final amended standard.
DOES FASB 125 GUIDE THE SEPARATE FINANCIAL STATEMENTS OF THE SPE?
FASB 125 does not address the balance sheet accounting by the SPE, which is usually the
registrant for SEC filing purposes, or related trusts. The various structures, though, may
have implications for the form and content of audited financial statements, which may be
called for in 1934 Act filings. For pass-through certificate structures and for
Collateralized Mortgage Obligations (CMOs) accounted for as sales, financial statements
have typically been considered not applicable.
CAN I RECORD AN ASSET FOR SERVICING?
Yes, if the benefits of servicing are expected to be more than adequate compensation to
service the assets. [13] This would best be evidenced by the ability to receive (as opposed
to pay) cash upfront if the rights and obligations under the servicing contract were to be
assigned to another servicer.
33

34
Servicing is inherent to financial assets; however, it only becomes a distinct asset when contractually
separated from the underlying assets via a sale or securitization of the assets, with
servicing retained. [35] A servicer of the assets commonly receives the benefits of servicing —
revenues from contractually specified servicing fees, late charges and other ancillary revenues,
including “float” — and incurs the costs of servicing those assets. Typically in securitizations,
the benefits of servicing are not expected to be less than adequate compensation
to the servicer. Adequate compensation is the amount of benefits of servicing that would
fairly compensate a substitute servicer, should one be required, which includes the profit
that would be demanded in the marketplace. Adequate compensation is determined by the
marketplace; it does not vary according to the specific servicing costs of the servicer.
Therefore, a servicing contract that entitles the servicer to receive benefits of servicing just
equal to adequate compensation, regardless of whether the servicer’s own servicing costs
are higher or lower, does not result in recognizing a servicing asset or servicing liability.
FASB 125 makes no distinction between “normal servicing fees” and “excess servicing
fees.” The distinction made is between “contractually specified servicing fees” and rights to
excess interest (“IO strips”). Contractually specified servicing fees are all amounts that, in
the contract, are due the servicer in exchange for servicing the assets. These fees would no
longer be received by the original servicer if the beneficial owners of the serviced assets
(or their trustees or agents) were to exercise their actual or potential authority under the
contract to shift the servicing to another servicer. Depending on the servicing contract,
those fees may include: the contractual servicing fee, and some or all of the difference
between the interest collected on the asset being serviced and the interest to be paid to the
beneficial owners of those assets. [243]
Consider the following example:
Financial assets with a coupon rate of 10 percent are securitized. The pass-through rate
to holders of the SPE’s beneficial interests is 8 percent. The servicing contract entitles
the seller-servicer to 100 basis points as servicing compensation. The seller is entitled
to the remaining 100 basis points as excess interest. Adequate compensation to a successor
servicer for these assets is assumed to be 75 basis points. The following chart
graphically depicts the arrangement.
3
SECTION
Basis Points
200
175
150
125
100
75
50
25
0
IO
STRIP
SERVICING
ASSET
ADEQUATE
COMPENSATION
CONTRACTUAL
SERVICING FEE

Servicing assets created in a securitization are initially measured at their allocated carrying
amount, based upon relative fair values at the date of securitization. Rights to future interest
income from the serviced assets in amounts that exceed the contractually specified servicing
fees should be accounted for separately from the servicing assets. Those amounts
are not servicing assets — they are IO strips to be accounted for as described later.
Servicing assets are to be amortized in proportion to, and over the period of, estimated net
servicing income (the excess of servicing revenues over servicing costs). This is often
referred to as the net income forecast or proportional method of amortization. If the estimated
net servicing income in Month 1 represents 1 percent of the total (on an undiscounted
basis) of the estimated net servicing income over the life of the pool, then 1 percent
of the original asset recorded for servicing rights would be amortized as a reduction
of servicing fee income in Month 1. This is in contrast to a depletion or liquidation method,
which is based on declining principal balances or number of loans. The servicing asset must
be subsequently evaluated and measured for impairment as follows:
1] Stratify servicing assets based on one or more of the predominant risk characteristics
of the underlying financial assets. Those characteristics may include financial asset
type, size, interest rate, date of origination, term and geographic location.
2] Recognize impairment through a valuation allowance for an individual stratum. The
amount of impairment recognized shall be the amount by which the carrying amount
of servicing assets for a stratum exceeds its fair value. The fair value of servicing assets
that have not been recognized shall not be used in the evaluation of impairment.
3] Adjust the valuation allowance to reflect changes in the measurement of impairment
subsequent to the initial measurement. Fair value in excess of the carrying amount for
that stratum shall not be recognized. [37g]
Questions related to determining gain or loss on sale
Servicing is not a “financial asset” under FASB 125. Accordingly, there is a higher threshold
analysis of “risks and rewards” to achieve sale accounting when mortgage servicing
rights are transferred. See EITF Issues No. 90-21 and 95-5.
SHOULD I RECORD A LIABILITY FOR RETAINED CREDIT RISK, OR IS IT PART OF THE
RETAINED BENEFICIAL INTEREST IN THE ASSET?
The transferor should focus on the source of cash flows in the event of a claim by the trust.
If the trust can only “look to” cash flows from the underlying financial assets, the transferor
has retained a portion of the credit risk through its retained interest, and a separate obligation
should not be recorded. Possible credit losses from the underlying assets do affect,
however, the measurement of the fair value of the transferor’s retained interest. In contrast,
if the transferor could be obligated for more than the cash flows provided by its retained
interest and, therefore, could be required to “write a check” to reimburse the trust or
others for credit-related losses on the underlying assets, a separate liability should be
recorded at fair value on the date of transfer.
35

36
HOW ARE CASH RESERVE ACCOUNTS HANDLED? — WHAT IS THE “CASH-OUT” METHOD?
According to the FASB 125 Q&A Implementation Guide, Question 73, a cash reserve
account is a retained interest in transferred assets. This is true regardless of whether the
account is funded with the transferor’s own cash or cash is withheld from sale proceeds to
establish the account. If the transferor’s own cash is used, then for purposes of the gain or
loss calculation, the carrying amount of assets transferred is increased by the amount of
cash deposited. If the cash deposit is funded with amounts withheld from sale proceeds,
then for purposes of the gain or loss calculation, the amount of sale proceeds that is compared
to the allocated carrying amount of the securities sold is reduced by the amount
deposited. The net gain or loss recognized at the time of securitization will be affected by
this sequence of events. Assuming the securitization is accounted for as a sale, the reserve
account is recorded at its allocated basis, based on relative fair value on the transfer date.
If the cash reserve account is inside the securitization trust and the seller’s only entitlement
to it is through its ownership of some form of residual certificate, then no separate asset is
recorded for the account; rather, its fair value is included when estimating the fair value of
the residual interest. The fair value of a cash reserve account will usually have to be estimated
since there is no ready market for this type of asset.
Consider the following example:
Company A securitizes $100 million principal amount of loans, which produce excess
interest of 100 basis points per annum after servicing fees and interest paid to
investors. At the transfer date, $1 million in cash is deposited in an interest-bearing
cash reserve account outside of the securitization trust. In subsequent periods, all cash
distributions to which Company A as residual holder would otherwise be entitled are
deposited in the cash reserve account and reinvested in eligible short-term investments.
Any losses incurred on the pool are reimbursed to the Trust with funds transferred
from the cash reserve account. When the reserve account balance accumulates
to an amount in excess of 5% of the outstanding balance of the securitized assets, the
excess is released to Company A. At subsequent dates, additional amounts based on
lower percentages are scheduled to be released to the Company.
3
SECTION
Company A uses the “cash-out” method in its net present value calculation. Under this
method, Company A projects the excess cash flows (increased by anticipated reinvestment
income) as of the day they are available to the Company (the date(s) the amounts
are released from the cash reserve account). This is in contrast to the “cash-in” method
in which future cash flows are projected to occur earlier (and have a higher net present
value); they are projected to occur as of the monthly dates the 100 bp of excess interest
are generated on the loans (note that anticipated reinvestment income is excluded
from that calculation). Separately, an amount of losses to be reimbursed to the Trust
would be estimated.

According to question 75 in the FASB 125 Q&A Implementation Guide:
The cash-out method estimates the fair value in a manner consistent with paragraph 43
[the fair value requirements of FASB 125] (that is, both the entire period of time during
which the transferor’s use of the asset is restricted and the potential losses due to uncertainties
are considered when estimating the fair value of the credit enhancement).
The SEC staff goes even further. They have announced that the cash-in method could result
in a material misstatement of the financial statements, and several registrants have accordingly
been required to file restated financial statements.
HOW DOES FASB 125 TREAT IO STRIPS AND OTHER SECURITIES SUBJECT TO PREPAY-
MENT RISK?
IO strips, loans or other receivables that can be contractually prepaid or otherwise settled
in such a way that the holder would not recover substantially all of its investment are to be
carried at fair value, similar to investments in debt securities classified as available for sale
or trading under FASB 115. [14] This will apply regardless of whether these assets were purchased
or were retained in a securitization. Note that some of these assets (e.g., uncertificated
interest strips) were not previously subject to FASB 115 because they did not meet
the definition of a “security.”
Questions related to determining gain or loss on sale
No guidance is given as to the size of a premium that would trigger this provision.
However, the FASB staff has said that the probability of prepayment is not relevant in deciding
whether this provision should apply. So the potential for the loss of a portion of the
investment would not be evaluated differently for a wide-band Planned Amortization Class
(PAC) class vs. a support class. For most residual assets classified as available for sale, the
write-down for the “other than temporary impairment” test specified in EITF 93-18 also
applies. The 93-18 test calls for an income statement write-down to fair value, whenever the
present value of the estimated future cash flows discounted at a risk-free rate is less than
the amortized cost basis of the instrument. This impairment test must be performed on a
deal-by-deal (asset by asset) basis. Unrealized appreciation in one asset cannot be used to
offset impairment to be recognized on another asset. For those assets classified as trading,
the impairment test of 93-18 would not apply, since the assets are already marked to market
in earnings. Are there any special rules for mortgage bankers? (See page 39.)
37

38
Comparison of contractual servicing asset vs. IO strip accounting under FASB 125
Definition
Initial Recorded Amount
Adjusted Initial
Recorded Amount
Income Recognition
Balance Sheet
Carrying Value
Recognition
of Impairment
SERVICING ASSET
The value of amounts that, per the contract,
are due to the servicer for servicing,
if more than adequate compensation
Allocated cost-relative to fair market value
(FMV)
No adjustment
Amortized in proportion to and over the
estimated net servicing income
Allocated cost, less accumulated
amortization and valuation allowance
Through valuation allowance for an
individual stratum when carrying amount
exceeds fair value; change in valuation
allowance in earnings
IO STRIP
Entitlements to interest spread beyond
the specified servicing fee
Allocated cost-relative to FMV
Adjustment up or down to FMV through
earnings, if trading, or equity (other comprehensive
income), if available for sale
Trading: Marked to market
Available for sale: Level yield, prospective
adjustment under EITF 89-4
Fair market value
Trading: Marked to market
Available for sale: Write-down to fair
value under EITF 93-18 when yield is
less than risk-free rate
The difference in accounting between servicing fees and IOs could lead sellerservicers
to select a stated servicing fee that results in larger servicing assets and lower
retained IO interests (or vice versa), with an eye to subsequent accounting. The potential
accounting incentives for selecting a higher or lower stated servicing fee may counterbalance
each other. On the other hand, because of this potential earnings volatility, many
issuers may look to ways to sell or repackage servicing and IO strips. Note that the transfer
of servicing is covered in EITF Issues No. 90-21 and 95-5, not FASB 125.
3
SECTION
At the time of this writing, the EITF has added to its agenda, Issue No. 99-20, Recognition
of Interest Income and Impairment on Certain Investments. Initially, the scope of the project
will be limited to retained interests classified as either held-to-maturity or available-forsale.
Existing GAAP does not provide robust guidance for the ongoing measurement of
interest income and other adjustments for securitized debt instruments whose cash flows
may change as a result of prepayments, credit losses, changes in an interest rate index and
other reasons. Multiple interest income accounting models have been developed and
applied for particular types of securities to deal with changes in their estimated future cash
flows. These include the retrospective method, the prospective method and the catch-up
method. Consider the following example:
You own a subordinated debt class from a securitization of mortgage loans. It has a principal
amount and a variable rate of interest. Losses on the underlying mortgage loans
in the pool are charged against this subordinated class before any losses are allocated

to the senior classes. Because of this feature, the security’s fair value and allocated basis
is significantly less than its principal amount. At inception, a certain amount of prepayments
and losses is expected. At the end of month one, (a) the actual interest rate on
the class changes; (b) the actual prepayments and the estimate of future prepayments
differ from the original expectation, and (c) the actual losses and the estimate of future
losses differ from the original expectation.
Question: How do you calculate interest income, including amortization of discount, in month 1?
Stay tuned for further developments at the EITF.
ARE THERE ANY SPECIAL RULES FOR MORTGAGE BANKERS?
A mortgage banking enterprise was not originally given the same latitude as other securitizers
with respect to the classification of retained interests in a securitization of its loans
under FASB 125. A mortgage banker (i.e., an entity engaged in mortgage banking activities)
was required to classify as trading (i.e., mark-to-market through earnings) all mortgagebacked
securities retained after the securitization of mortgage loans held for sale. Retained
mortgage-backed securities include senior and subordinated classes, IO strips and residuals.
In FASB 134, at the urging of the Mortgage Bankers Association of America, the FASB
decided to level the playing field and to conform the classification choices of a mortgage
banker to the classification choices of other securitizers pursuant to FASB 115. Now a mortgage
banker can classify retained securities based on its ability and intent to sell or hold
those investments, but is subject to the FASB 125 rule that IO strips and other premium
securities subject to prepayment risk must be classified as either available-for-sale or trading.
Also, in the event that a commitment to sell a tranche is made before or during the
securitization process, that security must be classified as trading.
Questions related to determining gain or loss on sale
Subordinated debt securities at a discount from face and Principal Only (PO) strips can be
classified as held to maturity and accounted for at amortized cost if the entity has the ability
and intent to hold those securities until maturity.
One does not have to have the intent to sell a security in the near term to classify the security
in the trading category. As pointed out in the gain on sale worksheet, the decision to
classify a retained mortgage-backed security as trading vs. available for sale has immediate
implications on the amount of income recognized in the period and possible future
implications when testing for impairment on a security by security basis.
39

40
WHAT IF WE PUT HUMPTY-DUMPTY BACK TOGETHER AGAIN?
A “desecuritization” is the process by which securities created in a securitization are transformed
back into their underlying loans or other financial assets. In EITF 90-2, a consensus
had been reached that an investor should record an exchange of IO and PO securities of the
same trust for the related mortgage-backed security at fair value at the date of the exchange
with gain or loss recognized on the exchange. However, since FASB 125 does not allow sale
treatment when an asset is exchanged for 100 percent of the beneficial interests in that
asset, it seemed logical to the FASB staff that sale treatment should not be allowed for the
opposite case of an exchange of all of the beneficial interests in the asset (e.g., senior and
subordinated classes) for the asset itself (e.g., the mortgage loans). Accordingly, EITF 90-2
has been nullified. See EITF Topic D-51, The Applicability of FASB Statement No. 115 to
Desecuritizations of Financial Assets.
3
SECTION
This booklet is written in general terms for widest possible use. It is intended as a guide only, and the application of its
contents to specific situations will depend on the particular circumstances involved, as well as, the status of any future
FASB interpretations or EITF issues. Accordingly, it is recommended that readers seek up-to-date information or
professional advice regarding any particular problems that they encounter. This guide should not be relied on as a substitute
for such advice.

STAY
TUNED
for
FURTHER DEVELOPMENTS

42
WHAT’S SLATED FOR 2001?
The more significant changes in the FASB’s Exposure Draft (ED) of their proposed amendments
to FASB 125 are summarized below. These amendments are slated to apply to transactions
after December 31, 2000 and cannot be applied earlier.
1] The definition of a QSPE is revised
According to the ED, a QSPE must be a trust or legal vehicle that meets all of the following
conditions:
4
BASIC GUIDANCE
The QSPE has standing at law distinct from the
transferor
The QSPE’s permitted activities are significantly limited
and are entirely specified in the legal documents
that establish the SPE or create the beneficial interests
in the transferred assets that it holds
It holds only:
1) Transferred financial assets
2) Financial assets arising from derivative instruments
(timing limitations apply)
3) Financial assets that assure third party servicing or
timely pay of obligations due the QSPE
4) Servicing rights for assets the QSPE holds
5) Temporarily, non-financial assets obtained in connection
with collection of financial assets the QSPE holds
6) Cash collected from financial assets it holds and
appropriate investments purchased pending distributions
(limitations apply)
If it can sell or distribute transferred assets to parties
other than the transferor or its affiliates, it can do so
only in response to one of three conditions
ADDITIONAL GUIDANCE
If a transferor holds all of the beneficial interests, it
appears that the trust does not have standing at law
distinct from the transferor.
The permitted activities may be significantly changed
only with the approval of the holders of at least a
majority of the beneficial interests held by entities
other than the transferor and its affiliates.
– A temporary holding of foreclosed nonfinancial collateral
would usually comply with point 5.
– A QSPE cannot hold the unguaranteed residual
value of a direct financing or sales-type lease.
– A QSPE cannot hold financial assets that would give
the SPE significant influence over another entity
(e.g. common stock in excess of 20%).
The conditions are:
– A decline in the fair value of transferred assets by a
specified degree below their fair value at the date of
transfer (triggered by a specified event or circumstance
outside the control of the transferor or its
affiliates).
– Exercise by a Beneficial Interest Holder (BIH) – other
than the transferor or its affiliates – of a right to put
that holder’s beneficial interest back to the SPE.
– Termination of the SPE or maturity of the beneficial
interests on a fixed or determinable date that is
specified at inception.
SECTION

2] Transferors, servicers and sponsors exclude the accounts of a QSPE from their financial statements
Assets sold to a QSPE are not recognized as assets of a transferor, sponsor or servicer nor
do these entities record as liabilities the related beneficial interests issued by a QSPE.
Why? The ED states that assets held in a QSPE are “effectively the assets of its [beneficial
interest holders].”
The guidance replaces EITF 96-20, although it effectively reaches the same conclusion.
Note that the ED does not address consolidation accounting by investors (other than
transferors, sponsors or servicers) in a QSPE. See footnote 9 on page 10.
3] The criteria for sale accounting are modified
FASB rejiggered the conditions for sale accounting (leaving alone the criterion for isolation).
The following replaces paragraph 9b and 9c criteria (FASB 125 devotees know
these paragraph numbers by heart):
Transfers to QSPEs:
1) The holders of beneficial interests have the right to pledge or exchange those
interests and no condition both constrains them from taking advantage of that
right and provides more than a trivial benefit to the transferor.
2) The transferor does not retain effective control over transferred assets through
the ability to unilaterally cause the transferee to return specific assets, other than
through a cleanup call.
Determining Whether the Securitization Meets the Sale Criteria
Transfers to entities other than QSPEs:
a) Each transferee obtains the right to pledge or exchange transferred assets, and
no condition both constrains it from taking advantage of that right and provides
more than a trivial benefit to the transferor.
b) 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 them before their maturity [e.g., most repurchase agreements].
4] Some securitizations that contain a Removal Of Accounts Provision (ROAP) cannot be accounted
for as sales
Hotly debated since the issuance of FASB 125 are so-called removal of account provisions,
usually found in revolving securitizations such as credit-card deals. The ED would nullify
the guidance of EITF 90-18 and narrow the types of ROAPs that are compatible with
sale accounting.
43

44
Which ROAPs would preclude sale accounting? Those that result in the transferor retaining
effective control over the transferred assets. It is critical that issuers review their
outstanding agreements because the ED does not grandfather existing structures. Thus,
if a deal involves an unacceptable removal of accounts provision, revolving transfers to
the vehicle after December 31, 2000 would be accounted for as financings.
Complicating the problem is the fact that ROAP revisions usually must be approved by
existing holders of outstanding beneficial interests.
Consult the table for guidance:
ROAP PROVISIONS
Unconditional ROAP or repurchase agreement.
The exercise of the ROAP is conditioned on a transferor’s decision
to exit some portion of its business (e.g., canceling an affinity
arrangement, spinning off a business segment, accepting a
bid for a specified portion of the business).
ROAP permits random removal of excess assets, if sufficiently
limited so that the transferor cannot remove specific assets.
ROAP permits removal of defaulted receivables.
ROAP is conditioned on a third party cancellation, or expiration
without renewal, of an affinity or private-label arrangement.
SALE ACCOUNTING IS PRECLUDED; THE ROAP
GIVES TRANSFEROR EFFECTIVE CONTROL
Yes
Yes
No
No
No
5] The reference to the powers of the FDIC is removed
The ED removes any reference to the FDIC (except in its Basis for Conclusions). Instead,
the ED notes that the powers of receivers not subject to the U. S. Bankruptcy Code vary
considerably, noting:
For entities that are subject to other possible bankruptcy, conservatorship, or other
receivership procedures in the United States or other jurisdictions, judgments
about whether transferred assets have been isolated need to be made in relation to
the powers of bankruptcy courts or trustees, conservators, or receivers in those
jurisdictions.
As a practical matter, we think that this proposed change will require that even entities
insured by the FDIC will need an appropriate opinion from competent legal counsel that
4
transferred assets have been isolated—unless the transfer is a straightforward sale
(e.g., there is no continuing involvement) of financial assets.
SECTION

THE FASB’s PROPOSED NEW DISCLOSURES
This appendix provides specific examples illustrating the disclosures that the FASB proposes
be required by December 31, 2000, with earlier application encouraged. The FASB’s format in
the illustrations below is not required; the Board encourages entities to use a format that displays
the information in the most understandable manner in the specific circumstances.
Note X below illustrates the disclosure of accounting policies for retained interests. In particular,
it provides a description for each major asset type of the accounting policies for (a)
initially measuring and (b) subsequently measuring the retained interests, including the
methodology for determining their fair value.
Note X – Summary of Significant Accounting Policies: Receivable Sales
When the Company sells receivables in securitizations of automobile loans and residential
mortgage loans, it retains IO strips, one or more subordinated tranches, servicing rights,
and in some cases a cash reserve account, all of which are retained interests in the securitized
assets. Gain or loss on sale of the receivables depends in part on the previous carrying
amount of the financial assets involved in the transfer, which is allocated between the
assets sold, if any, and the retained interests, if any, based on their relative fair value at the
date of transfer. To obtain fair values, quoted market prices are used if available. However,
quotes are generally not available for retained interests, so the Company generally estimates
fair value based on the present value of expected future cash flows using management’s
best estimates of the key assumptions—credit losses, prepayment speeds, and discount
rates commensurate with the risks involved.
Determining Whether the Securitization Meets the Sale Criteria
Note Y below illustrates disclosures about the characteristics of securitizations, the cash proceeds,
and gain or loss from securitizations for each major asset type.
Note Y – Sales of Receivables
During 19X2 and 19X1, the Company sold automobile loans and residential mortgage loans
in several securitization transactions. In all those securitizations, the Company retained servicing
responsibilities and subordinated interests. The Company receives (a) annual servicing
fees approximating 0.5 percent for mortgage loans and 1.5 percent for automobile loans
of the outstanding balance and (b) rights to future cash flows arising after the investors in
the securitization trust receive the return for which they have contracted. The investors and
the securitization trusts have no recourse to the Company’s other assets for failure of
debtors to pay when due. However, most of the Company’s retained interests are generally
restricted until investors have been paid or otherwise are subordinate to investor’s interests.
The value of retained interests is subject to substantial credit, prepayment, and interest
rate risks on the transferred financial assets.
45

46
In 19X2, cash proceeds from securitization of automobile loans and residential mortgage
loans totaled $512.7 million and $400 million, resulting in pretax gains of $22.3 and $25.6
million respectively.
In 19X1, cash proceeds from securitization of automobile loans and residential mortgage
loans totaled $300.7 million and $250 million, resulting in pretax gains of $16.9 and $15 million
respectively.
Table 1 below presents quantitative information about key assumptions used in measuring
retained interests at the time of securitization for each financial period presented:
Table 1:
Key economic assumptions used in measuring the retained interest resulting from securitizations
completed during the year were as follows:
19X2
19X1
Automobile Jumbo Mortgage Loans Automobile Jumbo Mortgage Loans
Loans Fixed-Rate Adjustable 2 Loans Fixed-Rate Adjustable 2
(Key rates, 1 all per annum)
Prepayment 1.00% 10.00% 8.00% 1.00% 8.00% 6.00%
Weightedaverage
life (in
years) 3 1.8 7.2 6.5 1.8 8.5 7.2
Expected credit
losses 3.10% 1.25% 1.30% 3.50% 1.25% 2.10%
Residual cash
flows
discounted at 12.00% 10.00% 12.50% 13.50% 11.75% 11.00%
Projected coupons
on floating rate
tranches is based
on the forward
LIBOR curve plus the
applicable spread
1
Weighted-average annual rates for securitizations entered into during the period for securitizations of loans with similar characteristics.
2
Rates for these loans are adjusted based on an index (for most loans, the 1-year Treasury note rate plus 2.75 percent). Contract terms vary,
but for most loans the rate is adjusted every 12 months by no more than 2 percent.
3
The weighted-average life of prepayable assets can be calculated by multiplying the principal collections expected in each future period by
the number of months until that future period, summing those products, and dividing the sum by the initial principal balance.
4
SECTION
Table 2 below combines disclosure of the key assumptions used in subsequently measuring
the fair value of retained interests at the end of the latest period and the hypothetical
effect on current fair value of two or more unfavorable variations from the expected levels
for each key assumption. This illustration provides up-to-date information about the key
assumptions used to measure the fair value of retained interests, highlights any change in
the key economic assumptions from those used to record the retained interests at time of
securitization, and describes the objectives, methodology, and limitations of the sensitivity
analysis or stress test.

Table 2:
At December 31, 19X2, key economic assumptions and the sensitivity of the current fair
value of residual cash flows to immediate 10 percent and 20 percent unfavorable changes
in assumptions are as follows:
(Amounts as of December 31, 19X2) Automobile Loans Jumbo Mortgage Loans
(in millions) Fixed Rate Adjustable
Carrying amount/fair value of retained interests $15.6 $12.0 $13.3
Weighted-average life (in years) 1.7 6.5 6.1
Prepayment speed assumption (annual rate) 1.3% 11.5% 9.3%
Impact on fair value of 10% adverse change $.3 $3.3 $2.6
Impact on fair value of 20% adverse change $.7 $7.8 $6.0
Expected credit losses (annual rate) 3.0% .9% 1.8%
Impact on fair value of 10% adverse change $4.2 $1.1 $1.2
Impact on fair value of 20% adverse change $8.4 $2.2 $3.0
Residual cash flows discount rate (annual) 14.0% 12.0% 11.0%
Impact on fair value of 10% adverse change $1.0 $.65 $.5
Impact on fair value of 20% adverse change $1.8 $.9 $.9
Interest rates on adjustable rate loans and tranches
Based on forward yield curve plus applicable spread
Impact on fair value of 10% adverse change $1.5 $.4 $1.5
Impact on fair value of 20% adverse change $2.5 $.7 $3.8
These sensitivities are hypothetical and should be used with caution. As the figures indicate,
the change in fair value based on a 10 percent variation in assumptions cannot necessarily
be extrapolated because the relationship of the change in assumption to the
change in fair value may not be linear. Also, in this table, the effect of a variation in a particular
assumption on the fair value of the retained interest is calculated independently
from any change in another assumption; in reality, changes in one factor may contribute to
changes in another, which might magnify or counteract the sensitivities.
Determining Whether the Securitization Meets the Sale Criteria
Table 3:
Table 3 below presents expected static pool credit losses.
Actual and Projected Credit Losses (%) as of:
Automobile Loans Securitized in
19X0 19X1 19X2
December 31, 19X2 5.0 5.9 5.1
December 31, 19X1 5.1 5.0
December 31, 19X0 4.5
Note: Expected static pool losses are calculated by summing the actual and projected future credit losses and dividing the sum by the principal
balance of the pool of assets at the time of securitization. The amount shown for each year is a weighted average for all securitizations during
the year. Static credit losses are not disclosed for mortgage loans because estimated losses are relatively small and the estimates have changed
very little over time.
47

48
Table 4:
Table 4 below presents cash flows between the securitization SPE and the transferor.
Cash flows received from and paid to securitization trusts were as follows:
Year Ended December 31
($000 omitted) 19X2 19X1
Proceeds from securitization during the period $913 $551
Excess cash flow received on retained interests 212 112
Servicing fees received 226 254
Purchases of delinquent or foreclosed assets (150) (25)
4
SECTION

fasb
125
Test Your Knowledge
QUIZ

50
TEST YOUR KNOWLEDGE PART 1
Buy-It, Sign-It, Drive-It, Inc. (“Buy-It”) purchases retail installment auto contracts from a network
of selected dealers in the Southwestern Region of the U.S. It has sustained its market
share in the face of increasing competition by intensely focusing on its niche.
Buy-It finances predominantly prime paper—the borrowers have solid credit histories and
make a significant down payment on the autos they purchase.
Buy-It also leases autos to customers under its “Why Pay?” program. Buy-It acquires title to
the cars and leases them to retail customers over 36 months, with a variety of customer choices
concerning initial minimum payments, ongoing monthly rentals and buy-out provisions.
Buy-It has sold some of its paper to Glorious Asset Trust, a multi-seller commercial paper
conduit managed by a regional Bank. The balance of the portfolio is financed on-balance
sheet via a combination of the Company’s equity and secured bank loans.
Buy-It is considering its first term auto loan securitization. The growing size of Buy-It’s originations,
the Company’s good reputation in the market place, and the strength of its servicing
operation all point to a successful securitization.
You envision a classical two-step structure for the securitization.
STEP 1
STEP 2
: Buy-It will form a wholly-owned bankruptcy remote special purpose entity,
Buy-It Financial Corp. (“Financial”). The loans will be transferred to
Financial as an equity contribution.
: Financial will transfer the loans to a newly formed entity, Buy-It Owner’s Trust
(“Trust”), in exchange for (1) cash and (2) a certificate, representing the residual
interest in the trust. Trust will finance the cash portion of the purchase
price by issuing multiple tranches of debt. Financial will distribute to Buy-It
the cash it receives from the Trust.
Other significant terms of the transaction are as follows:
• Buy-It will service the loans for a contractually specified servicing rate of 100 basis
points.
• Buy-It will have a call option on the sold loans when their principal is 10% or less of
4
the original balance sold; a level at which the cost of continuing to service is considered
burdensome.
• Buy-It sells all of the Class A and B tranches. As the residual holder, Buy-It is entitled to
the net margin enjoyed by the Trust; i.e., the difference between the yield on the auto
loans less the sum of the cost of the Trust debt, servicing, and ongoing administration.
SECTION

• Cash flow to the Residual Certificate is subordinated – all credit losses on the loans
are allocated in their entirety to the Residual Certificate. In the unlikely event that
credit losses exceed the Residual’s ability to absorb defaults, losses will be allocated
to the debt tranches in ascending order of priority.
• All-in transaction costs will run $1,375,000.
REQUIRED: WHAT’S THE BOTTOM LINE?
Determine the pre-tax gain or loss on the proposed sale in accordance with FASB 125,
using information presented in the case and in the Fact Sheet below. We suggest that you
create a worksheet like the template on page 30.
Fact Sheet
Loan Principal to be Securitized: $140 million
Loss Allowance Recorded at the Sale Date: $100 thousand
Expected Tranche Data:
Class Principal Rate Type Rate Sale Price
A-1 $65,000,000 Fixed 5.5% 100%
A-2 40,000,000 Fixed 6.0% 100%
A-3 30,000,000 Fixed 6.25% 100%
B 5,000,000 Fixed 6.55% 95%
Residual 0 Net Spread Net Spread N/A
Estimated Fair Value of Residual:
Determining Whether the Securitization Meets the Sale Criteria
Scenario Outcome Fair Value Amount* Major Assumptions:
Optimistic $4,600,000 Historical trends continue except pool performance data improves in six months due to
demonstrated effectiveness of new servicing system, increased training of personnel
and improved policies and procedures.
Best Estimate $3,750,000 Historical trends continue. Higher discount rate used due to recent industry developments
and estimated effect on liquidity of residual asset.
Pessimistic $2,450,000 Same as best estimate except prepayments/losses increase due to softening of
regional economy.
*These amounts represent a range of estimated fair values (i.e. willing buyer, willing seller) based on reasonable market based
assumptions as to credit losses, prepayment rates and discount rates.
Fair Value of Servicing Asset: $2.5 million
Based on the amount a successor servicer would pay to assume the servicing rights and obligations
51

52
Solution
The answer is $4,463,869.86. If you would like a copy of a worksheet showing the details of
the calculation, you can e-mail jamjohnson@dttus.com or mrosenblatt@dttus.com.
TEST YOUR KNOWLEDGE PART 2
The working group has assembled for an all-hands meeting. The objective of the meeting
is to nail down some of the gritty issues of the securitization – the following issues surface:
•The bankruptcy lawyers say: No doubt it should be a true sale at law. They’re evaluating
whether they can conclude that the transaction would be a true sale at law.
• The auditors ask if accrued interest at the sale date was factored into the gain
calculation.
•The rating agency wants more credit enhancement. Suggests company seed a $2.5
million reserve fund to be held by the trust, and allocate excess interest to the
reserve fund until it grows to 3.75 percent of the outstanding balance. Amounts in
the reserve fund would be invested in short-term, essentially risk-free, interest earning
assets. Funds in excess of the required amount would be released to Buy-It from
the reserve fund as a Residual Distribution.
• Securitization team proposes alternative credit enhancement. Utilize “Why Pay”
program. Transfer title to cars and assign related leases to Trust. Cash flow used
only to absorb credit losses; otherwise reverts to Buy-It. Noted gagging reaction
from lawyer and accountant.
•The CFO indicates initial calculation doesn’t include amounts related to dealer
reserves. Buy-It advanced $2.5 million to dealers for their portion of finance charges
related to certain loans in the pool. Under their arrangement with the dealers, the
dealers will refund the premiums if the loans prepay/default any time during the
first 120 days that the loans are outstanding.
Required:
Be prepared to discuss the effects of each of these points on the accounting for the securitization.
You need not quantify the effects.
4
SECTION

Solution
Meeting Point
Effect on Accounting for the Securitization
Uncertainty Over Legal Opinion Critical for sale accounting. The company’s outside accountants will need access to a legal opinion
that concludes that the transaction would be a true sale at law. Buy-It’s inability to obtain the appropriate
opinion may result in the Company accounting for the transaction as an on-balance sheet
collateralized borrowing.
Accrued Interest on Sale
The carrying value of the loans is understated and the gain is overstated. To correct the calculation,
Buy-It should include accrued interest in the carrying amount of the loan portfolio. Assuming that the
waterfall already includes the receipt of all interest payments after the transfer date, there would be
no effect on the fair value of the residual interest. Similarly, if the bonds are sold with pre-issue date
accrued interest, that amount should be considered as additional sales proceeds
Reserve Fund
Assets transferred would include the $2.5 million seed deposit and should be included in the basis
allocation. The waterfall should be recalculated, including the effects of the additional cash in the
trust on a cash-out basis and the residual certificate fair value amount increased by the result.
Using Operating Leased Assets Neither the autos under lease or the cash flows from an operating lease are financial assets as
as Credit Enhancement defined by FASB 125. Thus, FASB 125 does not apply to their transfer (other accounting literature –
FASB 13 – is on point).
Inclusion of nonfinancial assets in a securitization trust would usually result in Buy-It having to consolidate
the accounts of the Trust, (it is not a QSPE nor does it have third party equity) thus defeating
off-balance sheet sale treatment (see EITF 96-20). Also, inclusion of these assets might make it more
difficult for the attorneys to conclude that a true sale has occurred.
Dealer Reserves
Dealer reserves should be understood carefully – arrangements differ from entity to entity. In this
case, the carrying amount of the loans was understated by the advance Buy-It made when it acquired
the loans. However, Buy-It is also justified in recording an asset for the allocated fair value of the
amount it expects to recover from the dealers, which would offset some of the reduction of the gain.
Determining Whether the Securitization Meets the Sale Criteria
53

fasb
125
INDEX

Index
Adequate compensation 34
AICPA Auditing Interpretation on Lawyer’s Letters 17
Auction sales 20
Call reports 4
Cash-out Method 36
Cash Reserve Accounts 36, 52
Cleanup call 7, 12, 13, 26
Consolidation 10, 11, 12, 13, 14, 15
Convertible ARMs 8
Credit card example 31
Debt-for-tax 11, 12
Derivatives 9, 23, 29
Desecuritization 40
EITF Issue 93-18 37
EITF Issue 96-20 10, 11
EITF Issue 99-20 38
Excess servicing 34
Exposure Draft 42
Fair value 32
FASB 125 Q&A Implementation Guide 4
FASB 133 on Derivatives 23, 29
FASB 134 for Mortgage Bankers 39
FASIT 4,22
FDIC 16, 19, 44
5/1 ARMs 8
Float and ancillary fees 34
Gain on sale worksheet 30, 31
Impairment 35, 37
Insurance companies 4
Interest rate swap 9
International securitization 4, 16
Lawyers’ letters 17
Liquid asset 8
Low-level recourse 4
Money market tranche 8
Mortgage bankers 39
NAIC 4
Non-financial assets 4, 9
Put options 7, 12
Determining Whether the Securitization Meets the Sale Criteria
55

Qualifying special-purpose entity 6, 8, 9, 10, 11, 12, 13, 14, 15, 19, 20, 42, 43
Regulatory accounting principles 4
Removal of accounts provisions (ROAPs) 43
Revolving structures 28, 29, 31, 43
Risk-based capital 4
Rule 144A 7
Servicing 4, 33, 34, 35, 38
S.O.S. Speaking of Securitization 1
Statutory accounting practices 4
Topic D-14 of the EITF Abstracts – Special-Purpose Entities 11
Topic D-52 of the EITF Abstracts – Codification 4
Topic D-63 of the EITF Abstracts – Call Options 7, 12
Topic D-66 of the EITF Abstracts – Powers of an SPE 19, 20
Topic D-67 in the EITF Abstracts – Powers of the FDIC 16
Topic D-69 in the EITF Abstracts – SEC Views on Assumptions 33
Transferettes 29, 31
True sale at law 6, 15, 16
Two-step transfer 6, 15, 16
Uncertificated interest strips 37
Warehouse arrangements 13
This booklet is written in general terms for widest possible use. It is intended as a guide only, and the application of its
contents to specific situations will depend on the particular circumstances involved, as well as, the status of any future
FASB interpretations or EITF issues. Accordingly, it is recommended that readers seek up-to-date information or
professional advice regarding any particular problems that they encounter. This guide should not be relied on as a substitute
for such advice.

fasb
125
Securitization Accounting Under FASB 125
Y2K
EDITION
JANUARY 2000