Can you answer this question?
West Iowa Bank & Trust has invested in a bond issued by a collateral debt obligation (CDO) entity, Farm Acreage Receivables. As the name implies, Farm Acreage Receivables holds farmland mortgage receivables as collateral and sells packages of the mortgage cash flows to investors including institutions like West Iowa Bank & Trust.
Would the bank have to consolidate the CDO entity?
(Special thanks to Katie Mohrhauser, M.Ac 2009, for sending this question to The Iowa Ledger.)
Analysis: It depends. The determination of which party should consolidate a CDO requires an analysis of the facts and circumstances specific to that CDO transaction. We would look to the consolidation guidance in ASC Topic 810, Consolidation (Topic 810). If the CDO meets the definition of a variable interest entity (VIE), we would evaluate the CDO for consolidation under the Variable Interest Entity Subsection of Subtopic 810-10. If not, we would evaluate the CDO for consolidation under the General Subsection.
Paragraph 810-10-15-14 states that a variable interest entity is an entity that, by design, has one of the following conditions:
- The total equity at risk is insufficient to permit the entity to finance its activities without additional subordinated support
- The holders of equity at risk, as a group, lack the one of the following characteristics: the power to direct the activities that most significantly impact the entity's performance, the obligation to absorb the entity's expected losses, or the right to receive the entity's expected residual returns.
- The voting rights of some investors are not proportional to their obligation to absorb expected losses or receive residual returns, or substantially all of the entity's activities are conducted on the behalf of an investor with disproportionally few voting rights.
Assume the CDO does not meet any of the scope exceptions in paragraph 810-10-15-17. Also assume that we conclude, after considering all facts and circumstances, that the total equity at risk is insufficient to permit the CDO to finance its activities without additional subordinated support, such as the bank's bond investment. The CDO would have insufficient equity because its capital structure is primarily financed with bonds that would be classified as debt under US GAAP. Therefore, the CDO meets the definition of a VIE and the bank should evaluate the CDO for consolidation under the Variable Interest Entity Subsections of Subtopic 810-10.
The bank's investment meets the definition of a variable interest. Under Topic 810, the primary beneficiary is the entity deemed to have controlling financial interest in the VIE and should consolidate the VIE. Topic 810 provides two conditions of a controlling financial interest:
- "The power to direct the activities of a VIE that most significantly impact the VIE's economic performance."
- "The obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. The quantitative approach described in the definitions of the terms expected losses, expected residual returns, and expected variability is not required and shall not be the sole determinant as to whether a reporting entity has these obligations or rights."
We would consider the purpose and design of the CDO when assessing whether the bank is the primary beneficiary of the CDO. We would also identify the activities that most significantly impact the CDO's performance and who has the power over those activities. For example, in assessing condition (a), we might conclude that the activities that most significantly impact the CDO's economic performance are those related to the management of the CDO's asset portfolio. We would then need to determine whether any parties other than the collateral manager have control over those activities. In assessing condition (b), we would consider all economic interests, including direct financial interests, guarantees, derivative arrangements, as well as any transfer restrictions. After an analysis of all of the facts and circumstances, we would conclude whether the bank is the primary beneficiary.