FASB Recognition and Measurement of Derivatives Application of Statement 133 to Beneficial Interests in Securitized Financial Assets

FASB: Recognition and Measurement of Derivatives: Application of Statement 133 to Beneficial Interests in Securitized Financial Assets

Derivatives Implementation Group

Statement 133 Implementation Issue No. D1

Title: Recognition and Measurement of Derivatives: Application of Statement 133 to Beneficial Interests in Securitized Financial Assets
Paragraph references: 12–14, 310, Implementation Issue B36
Date cleared by Board: June 28, 2000
Date latest revision posted to website: June 16, 2006
Affected by: FASB Statements No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, No. 155, Accounting for Certain Hybrid Financial Instruments, and No. 156, Accounting for Servicing of Financial Assets
(Revised June 16, 2006)

Note: See Effective Date and Transition section for restrictions on the applicability of the interim guidance on this Implementation Issue.

QUESTIONS

The FASB staff has received the following inquiries regarding the application of the exception in paragraph 14 of Statement 133 to certain beneficial interests issued in securitization transactions subject to FASB Statement No. 125 (now FASB Statement No. 140), Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities:

  1. What types of instruments qualify for the exception in paragraph 14 of Statement 133? Does that exception apply to only certain interest-only and principal-only strips, or does it apply to other types of beneficial interests in securitized financial assets? Paragraph 14 of Statement 133 states:

        However, interest-only strips and principal-only strips are not subject to the requirements of this Statement provided they (a) initially resulted from separating the rights to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative that otherwise would have been accounted for separately as a derivative pursuant to the provisions of paragraphs 12 and 13 and (b) do not incorporate any terms not present in the original financial instrument described above.

  2. If the exception in paragraph 14 does not apply to some types of beneficial interests issued in securitization transactions, do those beneficial interests meet the definition of a derivative in paragraph 6 of Statement 133?

  3. If it is determined pursuant to Question 2 that some beneficial interests meet the definition of a derivative in paragraph 6 of Statement 133, how would that conclusion be reconciled to paragraph 3 of FASB Statement No. 134, Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise?

RESPONSE

With respect to Question 1, the staff believes that the exception in paragraph 14 of Statement 133 for interest-only and principal-only strips could be interpreted narrowly. That is, the notion in paragraph 14(b) that the interest-only and principal-only strips do not incorporate any terms not present in the original securitized financial asset could be interpreted to relate only to situations where the allocation of interest flows and principal flows is based on all or a specified proportion of those respective cash flows of the original instrument. However, the staff recognizes that some may have interpreted paragraph 14(b) more broadly to encompass certain beneficial interests other than interest-only and principal-only strips, because they view securitization transactions generally as a reallocation of the cash flows of the original securitized assets. For example, some may have interpreted the scope exception in paragraph 14 to encompass those beneficial interests that involve prioritization of cash flows due to prepayment risk or credit risk, because those risks are present in the original securitized assets. The staff understands that use of the phrase any terms not present in paragraph 14(b) has created some confusion.

The staff further understands that some may have interpreted paragraph 14 as excluding all interests that continue to be held by a transferor (previously referred to as retained interests) from Statement 133 because of the reference to retained interests in paragraph 310 in the basis for conclusions. Paragraph 310 states, in part, “Accordingly, the Board decided to exclude from the scope of this Statement interest-only and principal-only strips that meet the criteria in paragraph 14 and further consider the accounting for them in conjunction with its consideration of accounting for retained interests in securitizations.” The staff observes that the language in paragraph 14 of Statement 133 makes no comments that distinguish between interests that continue to be held by a transferor in a securitization transaction and those that are held by third-party investors.

A narrow interpretation of paragraph 14 could require many beneficial interests in securitized financial assets to be assessed to determine whether they meet the definition of a derivative in its entirety pursuant to paragraph 6 of Statement 133. With respect to Question 2, the staff is aware that questions have arisen about how the characteristics of a derivative in paragraph 6 of Statement 133 should be applied to beneficial interests that are subordinated to other interests.1a

With respect to Question 3, the staff acknowledges that some perceive a conflict between the scope of Statement 133 and the provisions of paragraph 3 of Statement 134, which permits mortgage-backed securities that continue to be held by a transferor after the securitization of mortgage loans held for sale to be classified in accordance with the provisions of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities—guidance that is analogous to the provisions of paragraph 14 of Statement 125 (now Statement 140).1 Statement 133 amended paragraph 14 of Statement 125 to add the following introductory phrase: “Except for instruments that are within the scope of Statement 133.” However, the language in paragraph 3 of Statement 134, which amends FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, omitted that introductory phrase. Thus, a conclusion that some mortgage-backed securities that continue to be held by a transferor (beneficial interests from a securitization) meet the definition of a derivative in their entirety would create a conflict with the amending language in paragraph 3 of Statement 134.

Given the issues outlined above, the staff believes the interpretation of the scope exception in paragraph 14 of Statement 133 and the determination of whether beneficial interests in securitized financial assets meet the definition of a derivative are complex issues that warrant further study. Further, if it is determined that some of those beneficial interests do not meet the definition of a derivative in its entirety, the staff believes further study may be required to determine whether the guidance in Statement 133 Implementation Issue No. B12, "Beneficial Interests Issued by Qualifying Special-Purpose Entities," is adequate to determine whether the beneficial interest has an embedded derivative that must be accounted for separately under paragraph 12 of Statement 133.

The FASB staff plans to discuss at a future Board meeting whether the Board should undertake a project to interpret Statement 133, Statement 125 (now Statement 140), or both. That project would resolve (1) which types of instruments qualify for the exception in paragraph 14 of Statement 133 and (2) whether beneficial interests in securitized financial assets that are subordinated to other interests meet the definition of a derivative in paragraph 6 of Statement 133.

Pending further guidance on those questions, entities may continue to apply the guidance related to accounting for beneficial interests in paragraph 14 and paragraph 362 of Statement 140. Paragraph 14 (as amended) states, "Interest-only strips, other interests that continue to be held by a transferor in securitizations, loans, other receivables, or other financial assets that can contractually be prepaid or otherwise settled in such a way that the holder would not recover substantially all of its recorded investment, except for instruments that are within the scope of Statement 133, shall be subsequently measured like investments in debt securities classified as available-for-sale or trading under Statement 115...."2 Paragraph 362 of Statement 140 amends Statement 115 similarly to indicate that any security that can be contractually prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment may not be classified as held-to-maturity. The interim guidance is not limited to securitizations involving qualifying special-purpose entities.

Because paragraphs 14 and 362 of Statement 140 require the majority of beneficial interests for which the various differing views on the application of Statement 133 are relevant to be measured like investments in securities classified as either available-for-sale or trading, the staff believes that the primary issue ultimately focuses on whether changes in the fair value of those interests can continue to be recorded in other comprehensive income or must be recorded in earnings. However, holders of beneficial interests in securitized financial assets that are not subject to paragraph 14 or paragraph 362 of Statement 140 are not required to apply Statement 133 to those beneficial interests until further guidance is issued.

For entities that have not yet adopted Statement 133, the interim guidance herein applies to all beneficial interests in securitized financial assets. An entity that has previously adopted Statement 133 and has accounted for a beneficial interest as either a derivative in its entirety or a hybrid instrument with an embedded derivative that is required to be accounted for separately shall not change its accounting for that beneficial interest. However, an entity in that situation is permitted to apply the interim guidance described herein to beneficial interests purchased after June 28, 2000, and to interests that continue to be held by a transferor in securitization transactions occurring after June 28, 2000. Alternatively, that entity is permitted to apply an interpretation of Statement 133 that the beneficial interest is either a derivative in its entirety or a hybrid instrument with an embedded derivative that must be accounted for separately.

At its June 28, 2000 meeting, the Board reached the above answer. Absent that, the staff would not have been able to provide interim guidance that would permit beneficial interests in securitized financial assets to be accounted for in accordance with paragraphs 14 and paragraph 362 of Statement 140 until the issues described herein are resolved.

EFFECTIVE DATE AND TRANSITION

Statement 155, which was issued in February 2006, addresses issues on the evaluation of beneficial interests issued in securitization transactions under Statement 133. Specifically, Statement 155 amends Statement 133 to 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. The FASB staff interim guidance in this Implementation Issue remains effective only for instruments recognized prior to the effective date of Statement 155.

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1aThe guidance in Statement 133 Implementation Issue No. A9, "Prepaid Interest Rate Swaps," also contributed to those questions, particularly with respect to the application of paragraphs 8 and 9(a). Implementation Issue A9 was superseded by the issuance of Statement 133 Implementation Issue No. A23, “Prepaid Interest Rate Swaps,” which does not affect the interim guidance in this Implementation Issue.

1As a result of Statement 134, in practice, certain mortgage-backed securities that continue to be held by a transferor have been classified as available-for-sale. Paragraph 20 of Statement 134 states that the Board expects that many mortgage-backed securities that continue to be held by a transferor would not be classified as held-to-maturity because Statement 125 amended Statement 115 to indicate that a security may not be classified as held-to-maturity if that security can contractually be prepaid or settled in such a way that the holder of the security would not recover substantially all of its recorded investment. In addition, paragraph 3 of Statement 134 indicates that the securitizer must classify as trading any mortgage-backed securities that continue to be held by a transferor and that it commits to sell before or during the securitization process.

2As indicated in paragraph 295 of the basis for conclusions, the provisions of paragraph 14 of Statement 140 do not apply to situations in which only events that are not the result of contractual provisions, for example, borrower default or changes in the value of an instrument's denominated currency relative to the entity's functional currency, might cause a beneficial interest holder not to recover substantially all of its recorded investment. Pending resolution of the issues described herein, entities are not required to account for those kinds of beneficial interests in securitized financial assets under Statement 133.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.