FASB Change: Transparency at a Cost

Banks and credit card firms expect to take a hit from a proposed modification of the FAS 140 accounting standard.
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An impending change to the accounting rules governing off-balance-sheet financing could force a new round of losses and capital-raising at financial institutions.

The proposed modification of the FAS 140 accounting standard has mostly flown under the radar, but the issue has become a hot topic on recent earnings calls and is increasingly popping up in company filings with the

Securities and Exchange Commission


As with fair value accounting, investors would get more transparency into public companies if FAS 140 is modified. However, the rule change -- which could be implemented as early as January 2009 -- would also make matters worse for financial institutions that have already reported massive losses and raised dilutive new equity.

"We're in a credit crunch. The last thing people want to do is throw gasoline on the fire," says Robert Napoli, an equity analyst at Piper Jaffray.

The Issue

In April, the Financial Accounting Standards Board, or FASB, agreed in principal to eliminate qualified special purpose entities, which are the bankruptcy-remote off-balance-sheet accounting vehicles used by firms to securitize their loans.

Firms that would be heavily impacted by the change include banks and credit card companies such as

JPMorgan Chase

(JPM) - Get Report


Discover Financial

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. Even less obvious companies -- like


(KMX) - Get Report

, which relies on securitization to sell its used-car loans -- could be pinched.

The motivation to eliminate the off-balance-sheet accounting vehicles stems from the subprime crisis -- as investors in collateralized securities began using their rights to sell back such bonds to the giant financial institutions that originated them. Suddenly, banks were found to have all sorts of liabilities that were never stated on their balance sheets.


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, for example, heavily used structured investment vehicles, or off-balance sheet financing methods, to securitize its mortgage bonds. Citigroup was eventually forced to take many of these loans back on its balance sheet, which required a new round of capital-raising.

Even prior to the subprime crisis, off-balance-sheet financing was a controversial issue since the blowup of Enron related to off-balance-sheet financing that masked the firm's giant liabilities.


Some say the changes to FAS 140 are overdue. "The old rules probably did not make sense," says Tom Selling, an accounting expert who publishes



"The impact could be really big because these securitizations are highly levered," he says. "It is probably going to have the effect of decreasing equity because the liabilities don't budge and the assets have been going down (in value)."

So far, several firms have warned about the possible rule change in their recent 10-Q filings with the SEC.

Discover Financial, which uses off-balance-sheet vehicles to securitize a good chunk of its receivables, said in a filing that the rule change could require the firm to add about $26 billion of securitized receivables to its balance sheet, along with related debt.

Doing so would likely require the firm to add additional reserves to account for possible loan losses.

"As a result of the addition of the securitized receivables to our balance sheet, we may be required to increase capital for Discover Bank to satisfy regulatory capital requirements," Discover said in its filing.

In a typical securitization, a financial firm securitizes a basket of its loans off-balance sheet and sells various tranches of debt to investors that are backed by the cash flows from the loans. The financial firm typically keeps the equity, or first-loss piece of the securitization, on its own balance sheet. The securitization process allows the financial firm to have fewer risky assets on its own balance sheet, which reduces the firm's capital requirements under regulatory rules.

If off-balance-sheet vehicles were eliminated, then financial institutions could suddenly see assets and liabilities balloon on their balance sheets, which would likely require more reserve-building, or higher expenses.

In its most recent quarter, Discover had $20.5 billion of loan receivables on its balance sheet, with a loss reserve amount of 4.1%, which drops the net receivables to $19.7 billion. Assuming Discover brought the entire $26 billion on balance sheet at a similar 4.1% loss reserve rate, that could result in $1 billion pre-tax loss absorbed by shareholders' equity (which currently stands at $5.8 billion), according to



Discover declined to comment.

However, this may just be a worst-case scenario. At this point, no one knows exactly how the accounting rule will be finalized. FASB is still drafting the proposal, which could be delivered by the end of August.

"Much of this is not clear; there's uncertainty about the timing, about the nature of the transition and the regulatory capital impact," Discover Chief Financial Officer Roy Guthrie told investors in an earnings call in late June. "That has led us to maintain a very conservative bias to retain capital, and until these various uncertainties are resolved, we'll continue with that posture. Thus, we've not been active with our share-repurchase program during the quarter and are unlikely to move off that position for the time being."

Already, credit card companies and other financial institutions are complaining about the rule, industry experts say.

Napoli, the Piper Jaffray analyst, says he thinks the rule would be implemented at the earliest on Jan. 1, 2009. If it is implemented that early, he expects that only new securitizations would go on balance sheet, with previous amounts not going on the balance sheets until 2010 and later.

He also expects the accounting rules won't result in regulators demanding more capital from banks.

"The FASB goal, I think, is to increase clarity and visibility for investors and lenders," he says. "They're not trying to tank the companies."

At this point, it remains unclear if

Fannie Mae



Freddie Mac


will be subject to the rule change, he says.

A less obvious candidate that would be affected by the charge is CarMax. The used-car dealer is already dealing with sluggish sales of used vehicles and plummeting prices for SUVs.

CarMax, however, also provides financing for the bulk of cars it sells. The company then securitizes these loans in off-balance-sheet transactions, while keeping a small residual piece of the resulting asset-backed securities.

Lately, CarMax has not been booking many profits from this piece of the business. However, if it were forced to bring these loans back on its balance sheet, the company could be forced to reserve more capital against loan losses.

As of May 31, CarMax managed nearly $4 billion of these securitized receivables. This appears to be the total amount of assets that could come onto the balance sheet if FAS 140 is changed, under a worst-case scenario. The amount of the liabilities are not clear.

Assuming a similar 4% charge for reserves (as at Discover), then CarMax could face a $160 million pre-tax loss, according to


calculations. That could wipe out the $138 million of profit that analysts expect CarMax to earn for its fiscal year ending February 2009.

CarMax did not return a call seeking comment.

While the ultimate ramifications of the accounting-rule change are not yet know, investors should keep an eye on the issue and understand how it could result in sudden large losses at various financial institutions.

It won't be surprising if the rules end up being less stringent than originally planned. Then again, it's better to err on the side of caution at this stage in the game.

As originally published, this story contained an error. Please see

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