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Berkshire Hathaway
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A Question for the Accounting Folk

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By jmls
September 23, 2002

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mjohn707 wrote:

"I just finished the 2000 Capital One Annual Report, and I'm thoroughly confused by this whole "Gain On Sale" accounting thing. Does anyone know how it works? The Capital One people just keep gibbering on about subordinated non-transferable interests, bi-model securitization effects, and residual risk. It would be really nice to have all this translated into English."

Dear mjohn,

I'm not really an accounting guy, but I've downloaded the 2000 Capital One annual report and I'll give a crack at it. Can you point out some specific sections?

In general terms though, I think they are talking about securitizing their loans and selling them. Often banks and other financial institutions like to repackage and resell their loans to other entities. This is very common with asset-backed loans, like mortgages, credit card loans and auto loans. Banks always get a servicing fee from this type of loan, if they can sell the loan to someone else they can reduce risk and get money up front to make more loans. OTOH other types of institutions may have use for asset-backed debt, which is higher yielding than normal debt. Berkshire and other insurers own a lot of asset backed debt, other examples include pension funds and bond funds.

It is usually hard to resell an individual mortgage or other such security though, there are a lot of specific risks (will this guy default? will there be a downturn in real estate in this area?) What they do instead is pool a bunch of these loans in a trust or other entity, which reduces individual risk because the pool is diversified. There are other things that can be done with this pool of loans, depending on who you sell to.

One thing which may be done from here is to sell "tranches" of the pooled loans. An individual 30 year mortgage almost certainly shall be paid off before 30 years, but how fast it is prepaid depends on many things. If interest rates drop, there will be a lot of refinancings (like are going on right now), so there will be a lot of mortgages paid in advance. OTOH if rates rise, people will pay their mortgages off very slowly. This large variability in speed of payment makes the mortgages less attractive to investors. One way to reduce some of this variability is to divide payments into say the first 20% to be paid (the first "tranche"), the second 20% etc. By doing this, you might find that the first tranche gets paid off in anywhere from 8-12 years, vs. say 8-20 for the mortgage overall. So the first few tranches, with more predictable duration, are easier to sell. A lot of the variability gets stuffed in the last tranche, which usually is very hard to sell; so banks usually keep these, this is part of "residual risk".

You can do other clever things with these pools of loans. You might sell notes for payment of interest only, or principal only. I think (?) under certain circumstances you can get a tax break if instead of reselling loans you instead sell preferred shares in the trust itself. There are a bunch of models to estimate the risk in various circumstances. I suspect a bunch of the jargon you are reading comes from their descriptions of what they are doing and how they are modeling it.

Best,

Lleweilun Smith


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