SPVs and Securitisations

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SPVs and Securitisations
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Disclaimer
Merrill Lynch is providing the information contained in this presentation to you for information purposes only and without representation or warranty, express or implied, by Merrill Lynch as to its accuracy or completeness and without any responsibility on Merrill Lynchs part to revise or update the information. Furthermore, Merrill Lynch is not providing this information to you in any form of fiduciary or advisory capacity and you will make your own analysis of the information and in doing so will consult with your own, independent financial, accounting and other advisors as you consider necessary.
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Agenda

• US GAAP vs IAS 39 different but similar
• Securitisations under IFRS
• Securitisations under IFRS - Examples
• Collateralised debt obligation
• Residential mortgage backed securitisations
• Credit linked notes

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US GAAP vs IAS 39

• FAS 140 derecognition is based on a control
  approach which centers on legal isolation
• FIN 46 consolidation based on a risk and rewards
  approach
• Consider consolidation of SPV after determine
  derecognition
• SPV consolidation is determined by status of SPV
  QSPE vs VIE
• Determination of derecognition is based on
  meeting specific criteria

• IAS 39 derecognition is based on risk and rewards
  with control
• Prior to derecognition must consider if
  consolidate the SPV
• Consolidation of SPV is based on a risk/rewards
  and control model
• A pass-through concept is present but no use of
  QSPV
• No specific exceptions to guidance
• Derecognition is based on answer to specific
  questions through a flow chart

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IAS 39 - Derecognition
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Introduction and background

• IAS 39, Financial Instruments Recognition and
  Measurement
• Includes derecognition of financial assets and
  liabilities
• Decision tree introduced
• Risks and rewards tests applied before control
  test
• Accounting treatment three possible outcomes
• Derecognition
• Continued recognition
• Continued recognition to the extent of continuing
  involvement
• SIC 12, Consolidation Special Purpose Entities
• Provides explicit guidance on the consolidation
  of SPEs
• SPE should be consolidated when indicators of
  control are present
• No qualifying special purpose entities

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Consolidation first, then possible derecognition

• First step is to consolidate all subsidiaries
  (including SPVs under SIC 12)
• If consolidation required derecognition of
  assets and liabilities may be possible, if
  (decision tree on next slide)
• Entity has transferred its rights to receive cash
  flows from the assets
• Entity has assumed obligation to pay cash flows
  from assets to eventual recipients
• Entity has transferred substantially all risks
  and rewards
• Three possible outcomes of derecognition test
• Derecognition of assets and liabilities
• Continued recognition of assets and liabilities
• Continued recognition of assets and liabilities
  to the extent of continuing involvement

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Derecognition of securitised assets
2. Has the entity transferred its right to
receive the cash flows from the asset?
1. Consolidate all subsidiaries (including any
SPEs)
No
Continue to recognise the asset
3. Has the entity assumed an obligation to pay
the cashflows from the assets that meets the
pass-through criteria
No
Determine whether the derecognition principles
are applied to a part or all of an asset (or
group of similar assets)
Yes
Yes
Derecognise the asset
4. Has the entity transferred substantially all
risks and rewards?
Yes
No
Continue to recognise the asset
No
5. Has the entity retained substantially all
risks and rewards?
Yes
Have the rights to the cash flows from the asset
expired?
No
Derecognise the asset
6. Has the entity retained control of the asset?
No
Yes
Derecognise the asset
Yes
7. Continue to recognise the asset to the extent
of the entitys involvement
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Consolidate all subsidiaries

• First step is to assess all subsidiaries for
  consolidation (IAS 27) includes determining if
  SPEs must be consolidated (SIC 12)
• To avoid consolidation, following indicators of
  control must not be present (for the reporting
  entity)
• activities being conducted on its behalf from
  which it draws benefits
• decision making powers to control or obtain
  control of the SPE or its assets
• rights to obtain majority of benefits of the SPE
• majority of risks of each party engaging in
  transactions with the SPE
• Must every SPE be consolidated by someone?
• SIC 12 notion that SPEs activities must be
  conducted on somebodys behalf and so as to meet
  somebodys business needs

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Derecognition

• Even if SPE must be consolidated due to SIC 12,
  may still be able to derecognise assets but must
  achieve pass through
• When entity collects cash flows on an asset and
  passes some or all to another entity, must fulfil
  all three requirements
• Have no obligation to pay amounts unless it
  collects equivalent amounts from the original
  asset,
• Entity is prohibited from selling or pledging the
  original asset, and
• Entity is obligated to remit any cash flows it
  collects without material delay. No investment
  for own benefit, only in cash and cash
  equivalents.
• Reinvestment in similar assets (securitisations
  involving short term assets) will most likely not
  qualify

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Securitisations under IFRS - Examples
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Example securitisations Collateralised Debt
Obligations (CDOs)
Asset manager
Trustee
Aaa floating/fixed rate notes
Underlying securities
Issued securities
Underlying collateral (eg. bonds/loans)
SPV
Baa floating/fixed rate notes
Cash
Cash
Swap provider
Unrated notes/ equity
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Example securitisations Collateralised Debt
Obligations (CDOs)

• Overview of structure
• Assets are transferred directly to the SPV by the
  arranger, or sourced directly from the market
• Assets are actively managed within predetermined
  guidelines
• SPV will inter into a swap transaction to modify
  the cash flows
• Note holders will receive a market interest rate
  and their notes are secured on the underlying
  portfolio of assets and
• Structure will include several tranches of debt
  from the AAA notes to the subordinated debt
  piece, which, along with the equity will absorb
  the first loss on the underlying assets.
  Consequently the risks of the different note
  holders will vary.

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Example securitisations Collateralised Debt
Obligations (CDOs)

• Accounting analysis applying the flow chart
• Consolidation of the SPE?
• If the party that transferred the assets to the
  vehicle owns a majority of the equity or
  purchased subordinated debt it will be hard for
  the transferor to prove he/she does not
  consolidate the vehicle
• If the asset manager is subject to a significant
  performance related fee (manager exposed to
  variability in earnings) the manager may have to
  consolidate
• Has the entity transferred its rights to receive
  cash flows from the assets?
• Transfer may be through a true sale of the
  underlying instrument. Should the transferor
  consolidate the SPE then the asset would need to
  satisfy the pass-through criteria
• Have the pass-through conditions been met?
• For the party who controls the vehicle, must be
  met from the perspective of the reporting group
• Has the entity transferred substantially all the
  risks and rewards?
• Requires a detailed assessment of the position of
  the transferor of the assets, the swap provider,
  the asset manager, and the note holders

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Example securitisations Residential
Mortgage-Backed Securitisations
Assignment of mortgages
Loan Note
Issued note
Originator
SPV
Cash
Cash
Subordinated loan

• Overview of Structure
• Originator transfers the residential mortgages to
  the SPV by equitable assignment, at an agreed
  upon value plus an amount of deferred
  consideration
• Deferred consideration enables the excess profit
  in the SPV to be transferred back to the
  originator
• Structure is credit enhanced by a subordinated
  loan from the originator to the SPV
• Originator continues to administer loans under a
  servicing agreement for an arms length fee and
• SPV issues loan notes secured by the mortgages to
  third parties who receive a market interest rate
  for their investment

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Example securitisations Residential
Mortgage-Backed Securitisations

• Accounting analysis applying the flow chart
• Consolidation of the SPE?
• Originator is exposed to the first loss of the
  SPV through its subordinated loan, while it
  receives the excess spread through the deferred
  consideration
• Therefore, originator has rights to the majority
  of the benefits and may be exposed to risks
  incident to the SPV and would most likely
  consolidate
• Has the entity transferred its rights to receive
  cash flows from the assets?
• No, originator continues to receive the
  underlying cash flows from the mortgages
• Have the pass-through conditions been met?
• Cash flows received by SPV are only paid out as
  they are received
• Cash must be held only until next coupon date
  with no interest earned by originator
• Has the entity transferred substantially all the
  risks and rewards?
• Originator exposed to the first loss and receives
  excess spread, unlikely to be considered a
  transfer

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Example securitisations Credit Linked Notes
Sale of collateral
Issued note
Structured Note
SPV
Investment Bank
Cash
Cash
Credit default swap on underlying reference name

• Overview of Structure
• SPV issues the note to the investor. Investor
  receives a return commensurate with the risk of
  the reference name and is at risk of losing the
  principal amount if there is a credit event on
  the underlying reference name
• Proceeds are used to purchase high quality
  collateral (e.g., government bonds) and
• Through the credit default swap, the SPV receives
  the additional coupon necessary to pay the note
  holder, in excess of the income on the
  collateral. SPV pays investment bank nothing
  unless there is a credit event on the
  underlying reference name.
• If there is a credit event the nominal value of
  the note will be paid to the investment bank.

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Example securitisations Credit Linked Notes

• Accounting analysis applying the flow chart
• Consolidation of the SPE?
• Structure generally setup on autopilot by
  investment bank
• CDS must be transacted at market rates to prove
  the investment bank does not control SPV
• Has the entity transferred its rights to receive
  cash flows from the assets?
• Assuming investment bank does not control SPV, it
  must assess whether the sale of collateral
  qualifies for derecognition
• Have the pass-through criteria been met?
• If investment bank does not control SPV,
  pass-through criteria must be considered from the
  perspective of the group
• The timing mismatch between when the cash flows
  are received and paid out by the SPV must not be
  greater than the time until the next coupon date
• All interest earned during the timing mismatch
  must be paid out to the note holders
• CDS will be recorded at fair value in accordance
  with IAS 39

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QUESTIONS?