In plain English, much of the securitization model that has fueled the modern mortgage market is tied to what’s known as a Qualifying Special Purpose Entity — or QSPE for short, and often called “the Q” in industry slang. QPSEs receive off-balance sheet treatment, or “sale accounting” treatment, that has largely enabled much of the growth in modern secondary markets. As HW readers know, the Federal Accounting Standards Board is looking to amend its consolidation standard for QSPEs (and other off-balance sheet vehicles), with an effective date now in 2010; in particular, the FASB has proposed eliminating the construct of the Q altogether. Such a move could prove problematic for many financial institutions that have been big players in the mortgage market, given that more than $10 trillion in assets currently live outside the balance sheet, according to SIFMA estimates. With that in mind, a group of Wall Street executives on Wednesday came out with a wide-ranging 172-page report that addressed various aspects on the ongoing credit crisis — but in the report was a detailed, and often surprising, analysis and set of recommendations on how to best handle the issues surrounding “the Q” going forward. The group releasing the report, the Counterparty Risk Management Policy Group III, is a private industry group of chief risk officers and other execs from large commercial and investment banks; the group was formed to generate an industry response the crisis. And you might have expected them to have recommended that “the Q” be allowed to stay, or at the very least that assets forced onto balance sheets by the elimination of the Q be forward-looking only (that is, existing off-balance sheet elections are allowed to stay put). Nope. The group came out Wednesday and recommended on-balance sheet consolidation of QSPEs — including existing Qs. Not exactly the response you might expect. But the tone of the entire report takes a sobering look at the factors driving systemic financial risk, and suggests that the pain of bringing Q assets onto a balance sheet would be better for the system in the long run. To understand the gravity of the recommendation, you need to understand the implications of wiping out the Q election for mortgage participants. From the report: “The result of these changes is expected to significantly increase the recognized balance sheets of financial institutions that sponsor and underwrite securitizations … The increase in balance sheet size will highlight the need for adequate financial statement presentation and disclosures to disaggregate and explain the consolidated balance sheet, for example, linking consolidated assets with related consolidated liabilities.” The report also notes that the impact of the Q’s death will reach into income statements, as consolidation “could also impact reported earnings if it results in the elimination of previously recognizable profits or losses, which would now be viewed as intercompany in nature and therefore not recognizable under US GAAP.” “Additionally, these changes are expected to have broad implications for many other areas outside of financial reporting such as regulatory capital ratios, debt covenants, and other contractual obligations,” write the report’s authors. In other words, even if you don’t understand how the secondary market operates, understand this: securitization as we know it seems set to change. Is it any wonder that Paulson & Co. have begun stumping for a covered bond market? “Costly as these reforms will be, those costs will be minuscule compared to the hundreds of billions of dollars of write downs experienced by financial institutions in recent months to say nothing of the economic dislocations and distortions triggered by the crisis,” said E. Gerald Corrigan, a managing director at Goldman Sachs (GS) and former president of the New York Federal Reserve. “Individual institutions must be prepared to put aside specific interests in the name of the common interest,” he argued. Related links: Report on accounting consolidation Disclosure: The author held no positions GS when this story was published; indirect holdings may exist via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.

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