FASB Embedded Derivatives Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets

FASB: Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets

Derivatives Implementation Group

Statement 133 Implementation Issue No. B40

Title: Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets
Paragraph references: 13(b), 14A, 61(a), 61(d)
Date cleared by Board: December 20, 2006
Date posted to website: January 17, 2007

QUESTION

Are there circumstances in which a securitized interest in prepayable financial assets would not be subject to the conditions in paragraph 13(b) of Statement 133?

BACKGROUND

FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments, amended Statement 133 to, among other things, establish a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. As a result, upon the adoption of Statement 155, some securitized financial assets are required to be analyzed in accordance with Statement 133 for the first time. (Previously, holders of beneficial interests in securitized financial assets were not subject to Statement 133 if they elected to apply the guidance in Statement 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.")

Paragraph 14A of Statement 133 (as amended by Statement 155) states:

    The holder of an interest in securitized financial assets (other than those identified in paragraph 14) shall determine whether the interest is a freestanding derivative or contains an embedded derivative that under paragraphs 12 and 13 would be required to be separated from the host contract and accounted for separately. That determination shall be based on an analysis of the contractual terms of the interest in securitized financial assets, which requires understanding the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction. A holder of an interest in securitized financial assets should obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative exists.

Paragraph 13 of Statement 133 states:

    For purposes of applying the provisions of paragraph 12, an embedded derivative instrument in which the underlying is an interest rate or interest rate index that alters net interest payments that otherwise would be paid or received on an interest-bearing host contract is considered to be clearly and closely related to the host contract unless either of the following conditions exist:
  1. The hybrid instrument can contractually be settled in such a way that the investor (holder) would not recover substantially all of its initial recorded investment.6a

  2. The embedded derivative meets both of the following conditions:

    (1)  There is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor's initial rate of return on the host contract.

    (2)  For each of the possible interest rate scenarios under which the investor's initial rate of return on the host contract would be doubled (as discussed under paragraph 13(b)(1)), the embedded derivative would at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return (under each of those future interest rate scenarios) for a contract that has the same terms as the host contract and that involves a debtor with a credit quality similar to the issuer's credit quality at inception.

Even though the above conditions focus on the investor’s rate of return and the investor's recovery of its investment, the existence of either of those conditions would result in the embedded derivative instrument not being considered clearly and closely related to the host contract by both parties to the hybrid instrument. Because the existence of those conditions is assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity, the acquirer of a hybrid instrument in the secondary market could potentially reach a different conclusion than could the issuer of the hybrid instrument due to applying the conditions in this paragraph at different points in time. [Footnote 6 omitted.]

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6aThe condition in paragraph 13(a) does not apply to a situation in which the terms of a hybrid instrument permit, but do not require, the investor to settle the hybrid instrument in a manner that causes it not to recover substantially all of its initial recorded investment, provided that the issuer does not have the contractual right to demand a settlement that causes the investor not to recover substantially all of its initial net investment.

Paragraph 61(a) elaborates on the condition in paragraph 13(b) as follows:

    An embedded derivative in which the underlying is an interest rate or interest rate index and a host contract that is considered a debt instrument are considered to be clearly and closely related unless, as discussed in paragraph 13, the embedded derivative contains a provision that . . . could under any possibility whatsoever at least double the investor’s initial rate of return on the host contract and at the same time result in a rate of return that is at least twice what otherwise would be the then-current market return for a contract that has the same terms as the host contract and that involves a debtor with a similar credit quality.

Paragraph 61(d) of Statement 133 elaborates on the applicability of paragraph 13 to embedded calls and puts in debt instruments as follows:

    Call options (or put options) that can accelerate the repayment of principal on a debt instrument are considered to be clearly and closely related to a debt instrument that requires principal repayments unless both (1) the debt involves a substantial premium or discount (which is common with zero-coupon bonds) and (2) the put or call option is only contingently exercisable, provided the call options (or put options) are also considered to be clearly and closely related to the debt host contract under paragraph 13.

RESPONSE

Yes. A securitized interest in prepayable financial assets would not be subject to the conditions in paragraph 13(b) of Statement 133 if it meets both of the following criteria:

  1. The right to accelerate the settlement of the securitized interest cannot be controlled by the investor.

  2. The securitized interest itself does not contain an embedded derivative (including an interest-rate-related derivative) for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets.1

The objective of this guidance is to provide a narrow scope exception from paragraph 13(b) of Statement 133 for securitized interests that contain only an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets and that meet the criteria above. If a securitized interest contains any other terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument and those terms create an embedded derivative that requires bifurcation (ignoring the effects of the embedded call options in the underlying financial assets), that securitized interest would be subject to the requirements of paragraph 13(b) of Statement 133 (for example, an inverse floater).

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1See Effective Date and Transition for the delayed effective date for this criterion.

As discussed in Statement 133 Implementation Issue No. B39, "Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor," the conditions in paragraph 13(b) were intended to apply only to situations that meet the two conditions specified in paragraphs 13(b)(1) and 13(b)(2) and for which the investor has the unilateral ability to obtain the right to receive the high rate of return specified in those paragraphs. Questions later arose about whether that guidance was intended to apply to securitized interests when the underlying assets are prepayable. Because the securitization process allows for the reallocation of risk, the Board decided that the investor’s ability to obtain the right to receive the high rate of return specified in those paragraphs should not be the only condition considered when applying paragraph 13(b) to securitized interests. The Board decided to add another criterion to ensure that securitized interests are evaluated for embedded derivatives that are not related to the embedded call options in the underlying assets.

Whether the securitized interest itself contains an embedded derivative (including an interest-rate-related derivative) for which bifurcation would be required, other than an embedded derivative that results solely from the embedded call options in the underlying financial assets, should be determined in accordance with paragraph 14A of Statement 133. This assessment is expected to be simple for basic securitized interests but could be more difficult for complex securitized interests (for example, in securitizations involving the resecuritization of tranches from previous transactions, the analysis might require an understanding of each securitization making up the resecuritization transaction).

A securitized interest in prepayable financial assets that does not meet both of the above criteria is subject to the conditions in paragraph 13(b) of Statement 133. When assessing the conditions in paragraph 13(b) for those instruments, an entity must consider the effect of prepayment risk.

The table below illustrates the application of this guidance to specific securitized interests in prepayable financial assets. The analysis of the examples considers only paragraph 13(b) of Statement 133, which is the subject of this Issue. The examples provide no discussion of the requirements of paragraphs 12 and 13(a) of Statement 133; however, an analysis of those paragraphs would be required to determine whether the instruments meet criterion (b) of this Issue.

Example
Application of This Guidance
1. Guaranteed Single-Class Mortgage Pass-Through Security
A fixed-rate guaranteed single-class mortgage pass-through security is issued, whereby the net cash flows received on the underlying fixed-rate, prepayable, single-family mortgage loans are proportionately passed through to the investors. Both the interest and principal payments are guaranteed by a third party for a fixed market-based guarantee fee, and a servicer receives a market-based servicing fee that is expected to be more than adequate compensation. Both the guarantee fee and the servicing fee have priority over the payments to the investors. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

While the priority of the payments to the guarantor and servicer reallocates the cash flows, the example security meets the two criteria.

Conclusion: Paragraph 13(b) is not applicable to the guaranteed single-class mortgage pass-through security.

2. Securitization Trust Includes a Freestanding Derivative
Assume the same facts as presented in Example 1, except that the underlying prepayable single-family mortgage loans have a floating interest rate. The securitization trust also holds an interest rate swap that is designed to perfectly swap the floating interest rate assets to a fixed interest rate to match the payments on the fixed-rate guaranteed single-class mortgage pass-through security.

Because the addition of the freestanding derivative (the interest rate swap) does not create an embedded derivative that requires bifurcation in the guaranteed single-class mortgage pass-through security itself, the example security meets the two criteria.

However, if the notional amounts of the securitized loans and the interest rate swap do not match, the fixed-rate securitized interest would have to be evaluated for an embedded derivative because the financial instruments held by the entity might not provide the necessary cash flows.

Conclusion: Paragraph 13(b) is not applicable to the guaranteed single-class mortgage pass-through security.

3. Sequential-Pay Collateralized Mortgage Obligation (CMO)
An entity securitizes a pool of guaranteed single-class mortgage pass-through securities (identical to those described in Example 1). The principal payments received, including prepayments of principal, on the underlying collateral are not allocated proportionately to all investors (bond holders). Three classes of securities are issued, Class A, Class B, and Class C, which mature sequentially. All three classes participate in interest payments from the underlying collateral, but, initially, only Class A receives principal payments. Class A receives all principal payments, including prepayments of principal, until it is retired. Next, all principal payments are paid to Class B until it is retired, and so on. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

The analysis of the bonds requires the holder to assess the securitized interest in accordance with criterion (b) of this Issue. To determine whether the individual bond classes contain an embedded derivative that requires bifurcation, the investor would have to understand the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction. The holder should obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative that requires bifurcation exists. Because the securitized interests (assumed to be identical to those described in Example 1) included in the resecuritization do not contain any embedded derivatives and there have been no other changes in the cash flows that create other embedded derivatives that require bifurcation, criterion (b) of this Issue is met.

While the prepayment risk in the underlying financial assets is reallocated through the securitization process, concentrating prepayment risk in certain bond classes, all three classes in the example meet the two criteria.

Conclusion: Paragraph 13(b) is not applicable to any of the bond classes in the sequential-pay CMO.

4. Planned Amortization Class (PAC) and Companion CMO
An entity securitizes a pool of guaranteed single-class mortgage pass-through securities (identical to those described in Example 1). The principal payments received, including prepayments of principal, on the underlying collateral are not allocated proportionately to all investors (bond holders). Two classes of securities are issued, a PAC bond and a companion bond. The PAC bond is designed to reduce the prepayment risk to investors by transferring prepayment risk to the companion bond. The PAC bond offers a fixed principal repayment schedule that will be met if prepayment on the underlying collateral is within a specified range. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

The analysis of the bonds requires the holder to assess the securitized interest in accordance with criterion (b) of this Issue. To determine whether the individual bond classes contain an embedded derivative that requires bifurcation, the investor would have to understand the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction. The holder should obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative that requires bifurcation exists. Because the securitized interests (assumed to be identical to those described in Example 1) included in the resecuritization do not contain any embedded derivatives and there have been no other changes in the cash flows that create other embedded derivatives that require bifurcation, criterion (b) of this Issue is met.

While the prepayment risk in the underlying prepayable financial assets is reallocated through the securitization process, concentrating prepayment risk in the companion bond, the example securities meet the two criteria.

Conclusion: Paragraph 13(b) is not applicable to either the PAC or the companion CMO.

5. Inverse Floater CMO
A CMO is issued with a coupon that fluctuates inversely with a referenced rate. The underlying securitized financial assets are fixed-rate, prepayable, single-family mortgage loans. Two classes of securitized interests are issued, one with a coupon based on a referenced rate (for example, LIBOR) and the second with a coupon that fluctuates inversely with that same referenced rate (the inverse floater CMO). Cash flows received on the underlying collateral are first used to pay a servicer a market-based servicing fee that is expected to be more than adequate compensation. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

While the inverse floater CMO meets criterion (a) of this Issue, the fact that the coupon rate fluctuates inversely with the referenced rate results in the instrument failing criterion (b) of this Issue. The inverse floater contains an embedded interest rate derivative that requires bifurcation, and that embedded interest rate derivative does not result solely from the embedded call options in the underlying financial assets. Said another way, the inverse floater meets the conditions of paragraph 13(b) without consideration of the prepayment risk in the underlying mortgage loans.

Conclusion: Paragraph 13(b) would be applicable to the inverse floater. When assessing the conditions in paragraph 13(b), the holder must consider the effect of prepayment risk. Therefore, the holder may identify both an embedded derivative related to the prepayment risk and an embedded derivative related to the inverse interest rate risk, which would be combined and recorded as one instrument.

6. Interest-Only Strip and Principal-Only Strip
An interest-only strip and principal-only strip are created by separating the net interest cash flows from the principal cash flows received on a pool of guaranteed single-class mortgage pass-through securities (identical to those described in Example 1). The interest cash flows form one bond, which is the interest-only strip. The principal cash flows form the second bond, which is the principal-only strip. Additionally, the investor does not have the right to accelerate the settlement of the securitized interest.

As a result of the guarantee fee and the servicing fee in excess of adequate compensation in the underlying guaranteed single-class mortgage pass-through securities, neither the interest-only strip nor the principal-only strip qualifies for the scope exception in paragraph 14 of Statement 133.

The analysis of the interest-only and principal-only strip requires the holder to assess the securitized interest in accordance with criterion (b) of this Issue. To determine whether the individual bond classes contain an embedded derivative that requires bifurcation, the investor would have to understand the nature and amount of assets, liabilities, and other financial instruments that compose the entire securitization transaction. The holder should obtain sufficient information about the payoff structure and the payment priority of the interest to determine whether an embedded derivative that requires bifurcation exists. Because the securitized interests (assumed to be identical to those described in Example 1) included in the resecuritization do not contain any embedded derivatives and there have been no other changes in the cash flows that create other embedded derivatives that require bifurcation, criterion (b) of this Issue is met.

While the prepayment risk in the underlying prepayable financial assets is reallocated through the securitization process, concentrating prepayment risk in certain bond classes, both the interest-only strip and principal-only strip in the example meet the two criteria.

Conclusion: Paragraph 13(b) is not applicable to either the interest-only strip or the principal-only strip.

EFFECTIVE DATE AND TRANSITION

The guidance in this Issue shall be applied upon adoption of Statement 155 (except, in certain circumstances, for criterion (b)). Criterion (b) of this Issue is not applicable to securitized interests (a) that were issued before June 30, 2007, and (b) that only include embedded derivatives, other than an embedded derivative that results solely from the embedded call options in the underlying financial assets, that have an extremely remote possibility of having greater than a trivial fair value at any time during the instrument’s life (for example, an embedded derivative that only has value when an interest rate index reaches an extremely remote level) as determined on the adoption of Statement 155 or the purchase of the instrument, whichever occurs later. An entity that adopted Statement 155 prior to December 31, 2006, shall apply the guidance in this Issue in the first reporting period beginning before December 31, 2006, for which financial statements have not yet been issued.

If an entity had previously adopted Statement 155 and, in doing so, had treated derivatives embedded in a securitized interest in prepayable financial assets in a manner consistent with the guidance in this Issue, then that entity would not be required to retrospectively apply the guidance in this Issue to prior periods. An entity is not permitted to change the FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, classification of the instrument on the application of this guidance. However, if that entity had not treated derivatives embedded in a securitized interest in prepayable financial assets in a manner consistent with the guidance in this Issue, then that entity shall apply the guidance in this Issue retrospectively to the date of adoption of Statement 155. If in applying this guidance retrospectively the entity must recombine a host instrument with a previously bifurcated embedded derivative, that entity shall reverse any changes in the fair value of the embedded derivative that were previously recognized in income. Additionally, entities required to retrospectively apply the guidance in this Issue shall classify the instrument as follows:

  1. Entities that upon applying Statement 155 (1) previously identified embedded derivatives that no longer require bifurcation in accordance with the guidance in this Issue and (2) elected to measure the entire hybrid financial instrument at fair value under that Statement, may elect any appropriate classification in accordance with Statement 115 for the financial instrument.

  2. In all other circumstances, the resulting financial instrument (which may no longer be a hybrid financial instrument or may be a host instrument that is different from the prior host) shall be classified in the Statement 115 category previously elected for the prior host instrument.

DISSENT

One Board member, Mr. Trott, dissents from the issuance of this Implementation Issue. That Board member does not agree with providing a "prepayment" exception for deciding when an embedded derivative is considered to be not clearly and closely related to the host instrument. That Board member believes that the guidance in paragraph 13 should be applied to determine whether an embedded derivative is to be bifurcated and either accounted for separately under Statement 133 or accounted for under the option provided by Statement 155 of carrying the combined host and embedded derivative at fair value with changes reported in net income. One of the objectives of Statement 155 was to eliminate the scope exception in Statement 133 Implementation Issue No. D1, "Recognition and Measurement of Derivatives: Application of Statement 133 to Beneficial Interests in Securitized Financial Assets," for evaluating securitized beneficial interests for embedded derivatives. This Statement 133 Implementation Issue effectively reinstates this exception for a large number of securitized interests. The shifting of prepayment risk is one of the most common features of securitization of prepayable financial assets and this shifting of prepayment risk creates a significant embedded derivative that otherwise could meet the criteria for bifurcation. The tests in paragraph 13 were established in Statement 133 to provide a mechanical test for making an otherwise difficult judgment concerning whether the embedded derivative is to be accounted for as a derivative. This type of test was requested by many auditors and preparers. The reaction to applying the test some eight years after it was established based on the unpopularity of having to apply the test and the potential result of its application is not appropriate.


The above response has been approved by the Board by written ballot.


Appendix A: IMPACT ON STATEMENT 133 IMPLEMENTATION ISSUES

This appendix addresses the impact of the provisions of this Statement 133 Implementation Issue on the responses to other Statement 133 Implementation Issues through December 31, 2006.

Statement 133 Implementation Issue No. B39, "Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor," is amended as follows [added text is underlined and deleted text is struck out]:

  1. The "Paragraph 13(b) Applicable to the Embedded Call Option" section of Example 6 in the chart illustrating the guidance to specific debt instruments:

      No, unless the impacts of the embedded call feature are disproportionately allocated to interest holders Not Applicable (see comments).

  2. The "Comments" section of Example 6 in the chart illustrating the guidance to specific debt instruments:

      While the MBS itself does not contain an embedded call option, the Board decided as part of FASB Statement No. 155, Accounting for Certain Hybrid Financial Instruments, that an interest in MBS with underlying assets containing an embedded call feature, for which all of the associated cash flows are proportionately passed through to all the interest holders, will not be subject to the conditions in paragraph 13(b) with respect to that embedded call feature. However, in situations in which the cash flows associated with the embedded call feature are disproportionately allocated to different classes of interest holders, all interests in that MBS would be subject to the conditions in paragraph 13(b) with respect to that embedded call feature. Although the related mortgage loans are prepayable, and thus each contain a separate embedded call option, the MBS itself does not contain an embedded call option. While the MBS investor is subject to prepayment risk, the MBS issuer has the obligation (not the option) to pass through cash flows from the related mortgage loans to the MBS investors. Therefore, MBS are not within the scope of this Issue. Issue B40 addresses the application of paragraph 13(b) to securitized interests in prepayable financial assets.