Jon McDowell

Loan Participations & Definition of a Participating Interest

FAS 166 defines participating interest as establishing specific conditions for reporting a transfer of a portion of a financial asset as a sale instead of a secured borrowing. The statement defines a participating interest as:

• Conveying proportionate ownership rights with equal priority to each participating interest holder
• Involving no recourse (other than standard representations and warranties) to, or subordination by, any participating interest holder
• Not entitling any participating interest holder to receive cash before any other participating interest holder (reasonable servicing fees are not included in the cash flows for this determination nor are the proceeds received by the transferor as proceeds)
• Not allowing any party to pledge or exchange the entire financial asset unless all participating interest holders agree to pledge or exchange the entire financial asset

Upon adoption of this standard, institutions that sell loan participations must determine the loan participation meets the definition of a participating interest as well as the conditions for surrender of control specified by FAS 140. Both of these criteria must be satisfied for the sale to complete and get removed from the books of the transferor.

Certain provisions in loan participation agreements currently qualifying as sales will not qualify as a participating interest under the new guidance. One example is a so-called “last-in, first-out” provision allowing one participant to receive payments on its interest in the asset prior to another participant. This would not qualify because it allows a participating interest holder to receive disproportionate cash flows from the asset. Another example is a participation agreement with a pass-through interest rate to the participant that is substantially less than the contract rate. Most often, the difference between the pass-through rate and the contract rate is designed to compensate the transferor for servicing the loan. However, if the transferor is receiving an amount for servicing that is significantly above an amount that would compensate a substitute service provider, the participation would not qualify as a participating interest.

Any participations that do not qualify for sales treatment, either because they do not qualify as participating interests or because they do not effectively surrender control over the transferred asset, should be accounted for as secured borrowings.

Securitizations & Qualified Special-Purpose Entities

FAS 166 removes the concept of a qualifying special-purpose entity from FAS 140 and removes the exception from applying FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, to qualifying special-purpose entities. Therefore, after the effective date of this standard, formerly qualifying special-purpose entities will need to be re-evaluated for consolidation in accordance with the applicable consolidation guidance. This could cause previously independent entities to consolidate. The pronouncement provides transition guidance for this circumstance.

The statement also removes the special provisions in FAS 140 and FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, for guaranteed mortgage securitizations and requires them to be treated the same as any other transfer of financial assets within the scope of FAS 140, as amended. The statement also clarifies the transferor must evaluate whether it, its consolidated affiliates included in the financial statements being presented, or its agents effectively control the transferred financial asset directly or indirectly for the transfer to meet the provisions related to surrender of control.

Disclosures

FAS 166 requires enhanced disclosures to provide financial statement users greater transparency about transfers of financial assets and a transferor’s continuing involvement with transfers of financial assets accounted for as sales. The disclosures outlined in FAS 166 are only minimum required disclosures. Companies may need to supplement the required disclosures to meet objectives outlined in the statement.

Effective Date & Transition

The statement is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The recognition and measurement provisions of the statement apply to transfers that occur on or after the effective date.

As discussed above, existing, qualifying special-purpose entities must be evaluated for consolidation by reporting entities in accordance with the applicable consolidation guidance.

The disclosure provisions of the statement are applicable to transfers that occurred both before and after the statement's effective date.

Recent Federal Deposit Insurance Corporation (FDIC) Actions

In response to FAS 166, the FDIC recently approved a joint rulemaking to provide an optional two-quarter implementation delay of the effect on risk-weighted assets from the implementation of FAS 166. This was because many existing qualifying special-purpose entities not currently consolidated may be consolidated upon adoption of the statement. Find the joint rule at www.fdic.gov/news/board/DEC152009no2.pdf.

In response to the statement’s treating the FDIC as receiver or conservator of assets transferred by an institution in connection with a securitization or participation, the agency approved an Advanced Notice of Proposed Rulemaking. The FDIC seeks comments on standards to provide “safe harbor” treatment of these securitizations and participations after March 31, 2010, and require loan originators to retain an ownership stake in loans they package and sell. Since 2000, the FDIC has provided safe-harbor protections to securitizations by confirming that in the event of a bank failure, the FDIC would not try to reclaim loans transferred into a securitization so long as an accounting sale had occurred. However, with the changes in FAS 166, most securitizations will no longer meet the off-balance-sheet standards for sale treatment when they took effect on January 1, 2010. On November 12, 2009, the FDIC approved a transitional safe harbor that grandfathered securitizations or participations in process through March 31, 2010. Find the advanced notice of proposed rulemaking at www.fdic.gov/news/board/DEC152009no5.pdf.

Summary

FAS 166 makes significant changes to the requirements for sale treatment of financial asset transfers. These revised requirements were effective for most institutions January 1, 2010. We encourage institutions to take a detailed look at loan participation agreements to determine whether their provisions would preclude sale treatment for transfers subject to application of FAS 166.