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Some Bank Funding Contracts Will Be Treated as Secured Borrowings

December 26, 2013

The FASB agreed to update U.S. GAAP with a requirement that repurchase-to-maturity agreements be accounted for as secured borrowings and not sales. The change was prompted by the 2011 collapse of MF Global Inc., a high-profile commodities broker that used questionable accounting to mask the leverage on its balance sheet.

The FASB on December 18, 2013, approved a plan from its research staff to write a standard to amend the accounting for a type of short-term financing often used by securities and commodities firms.

The board’s decision means that U.S. GAAP will treat as secured borrowings contracts called repurchase-to-maturity agreements, which were used by the brokerage firm MF Global Inc. to fund its daily operations before its October 2011 collapse.

The accounting change will force companies that use the contracts to record them on their balance sheets. MF Global treated the contracts as sales, which left its investors uninformed about the amount of risk it was carrying.

The board expects to publish the standard early in 2014, and companies will have to follow the new rules for quarterly and annual periods beginning after December 15, 2014, which effectively means a 2015 implementation date. Private companies would also have to follow the guidance for annual financial statements after December 15, 2014, but would get an extra year to make changes to their interim financial reports. The board decided against allowing early adoption, except for the interim reporting by private companies.

The update will amend FASB ASC 860-10, Transfers and Servicing, formerly SFAS No. 140.

FASB member Thomas Linsmeier said he would dissent from the final standard, saying he generally disagreed with classifying repurchase-to-maturity agreements as borrowing arrangements. Expressing concerns about the footnote disclosures proposed in the draft standard, FASB Chairman Russell Golden said he was undecided as to whether he would endorse it.

The forthcoming standard stems from the January 2012 proposal, Proposed Accounting Standards Update (ASU) No. 2013-210, Transfers and Servicing (Topic 860): Effective Control for Transfers with Forward Agreements to Repurchase Assets and Accounting for Repurchase Financings.

The FASB kept the core of the proposal—a requirement that repo-to-maturity transactions are accounted for as loans—but made a few changes after reviewing feedback from auditors, investors, and companies.

Financial companies use repurchase agreements, or repos, to finance their daily trading. Typically, one party will sell assets or securities and receive Treasury securities or other liquid instruments in return and agree to buy them back at later date at a higher price. The agreements function as cash loans. In a repo-to-maturity, the buyback date is the maturity of the underlying asset, such as a two-year Treasury note or a 30-year mortgage bond.

MF Global, which is accused of being so leveraged it used customer funds to support its trading, regularly classified its repo-to-maturity agreements as sales and moved the assets off its balance sheet. The trades hid the amount of risk the firm was carrying, in part because the trades were tied to risky European sovereign debt. As the European financial crisis deepened, the company’s exposure worsened. The FASB began its work on the amendments it just finalized after Congress and the SEC investigated MF Global’s accounting practices.

The January proposal also tried to address accounting for mortgage dollar-rolls—a similar set of transactions that involve the sale of a mortgage-backed security with a simultaneous agreement to buy the instrument back at a later date.

The proposal attempted to add guidance on the application of the effective control criterion to help businesses determine whether financial assets transferred and bought back were “substantially the same.” In reviewing feedback on the proposal, the board decided to refocus the substantially-the-same characteristics based on the existence of trade stipulations. Dollar rolls with trade stipulations would have met the characteristics of “substantially the same,” while dollar rolls without them wouldn’t.

Many businesses and analysts told the FASB that the board still did not get it right, however. They said they do not pay as much attention to trade stipulations as they do to the market yield of the security to be returned.

Instead of trying to determine how to handle dollar-roll transactions in the context of this project, the FASB voted on December 18 to scrap the potentially confusing “substantially-the-same” guidance and address the dollar-roll issue separately.

“It is clear in our outreach that there’s one subset of the population of people that are entering into these transactions that are making judgments in one direction and another subset making judgments for the exact same types of transactions in another direction,” FASB member Lawrence Smith said. “I’d like to eliminate that but would like to eliminate it through some other project or perhaps an EITF [Emerging Issues Task Force] issue.”

FASB member Marc Siegel said a separate effort made sense because the transactions in question represented only “a small slice of the actual dollar-roll market.”

“Going through all this consternation to try to fix something that’s really only one-tenth—or I don’t even know what percentage—of the market overall, that definitely seems outside the scope of this project,” Siegel said.

The board also approved several disclosure requirements for the update.

The first set of disclosures deals with the quality of the assets involved in repo-to-maturity transactions, which the FASB said was important to help give insight into the risks involved in the deals. The disclosures include a breakdown of the gross proceeds and the gross obligation arising from the transaction; the fair value of the financial assets transferred; a weighted average contractual duration for each class of assets; and a discussion of the obligations if the fair value of the asset declines.

“What we’re asking for is at the heart of ‘Can you get cash when you need it?’ and I think the answer here is, ‘It depends on the quality of the assets that you have,'” FASB member Harold Schroeder said. “To me, this is critical to the whole project.”

Disclosures were also approved for transactions that will not be accounted for as secured borrowings. If the repurchase agreements are accounted for as sales, the FASB wants to know about the type of transaction, the ongoing exposure to the transferred financial assets, the carrying value or fair value of a forward repurchase agreement or swap contract, and other information.