Chapter 1, Introductory Cases Dublin Small Animal Clinic, Inc. 1 page; introductory



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Securitization

Sub-prime loans

Bankruptcy

Retained Interests

Accounting rules for off-balance sheet financing


This case covers securitization by one of the first firms to go bankrupt because of sub-prime and Alt A lending. The case gives an overview of an out-of-control mortgage securitization industry with virtually no oversight. It also is interesting because New Century classified some of its securitized mortgages as investments, so instead of including only its retained interest in mortgage securitization trusts (pools) on its balance sheet, New Century included the entire value of the pool’s assets (mortgages) and the entire value of the pool’s liabilities (issued notes).

Many FASB off-balance sheet financing rules are designed to prevent firms from improperly omitting liabilities from their balance sheets. Suppose a firm transfers $1 billion of mortgages to a securitization trust, the trust issues $950 million of notes to investors, and the trust then pays the $950 million to the mortgage originator. Should the mortgage originator only record a $50 million retained interest as an asset, or record $1 billion of mortgages as assets, and the $950 million of notes as liabilities? Most FASB securitization rules are designed to prevent firms from improperly reporting only the $50 million of retained interest. However, firms must provide relatively detailed disclosures about how they value retained interests. New Century seemed to purposely record the entire amount of mortgages in its securitization pools as assets, and the entire amount of notes issued by those pools as liabilities, so as to avoid disclosing information about its retained interests.

Legally, when New Century transferred mortgages to securitization pools, it no longer had an obligation to note holders; its only asset was a retained interest in the pools. However, New Century retained an option to reacquire the mortgages. Under FASB rules, New Century “controlled” the mortgages, so it was required to record both the mortgages and notes on its balance sheets. New Century clearly disclosed that rule and clearly also stated that although it could have disclosed its retained interest in the pools, it chose not to do so. That let New Century avoid disclosing the size of its retained interests, which were probably very high. It also let New Century avoid disclosing how it computed its retained interests.

The case is difficult but it does provide a good example of how detailed accounting rules have become and how firms can circumvent those rules.





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