The Financial Accounting Standards Board is exploring fair market valuation for both retained and purchased beneficial interests in securitizations. The notion was discussed in last week's session on the application of FAS 133 to securitizations.

Under the current interim guidance issued in 2000 (FAS 133 D1), beneficial interests with substantial prepayment risk must be accounted for as either available-for-sale or trading in accordance with paragraph 14 of FAS 140. Beneficial interests in a securitization not subject to substantial prepayment risk are accounted for under Statement 115 as held-to-maturity, available-for-sale or trading.

The Board is leaning toward Statement 115 trading value (fair value) for both retained and purchased beneficial interests, with an option to bifurcate any embedded derivatives as separate instruments under applicable GAAP.

One concern expressed, however, is that credit risk, for retained assets such as residuals, might not be reflected in the fair value. "Are we ready to go fair value for credit risk, or not?" asked one Board member.

FASB was not conclusive on where the eventual rules will appear. The Board discussed modifying or amending paragraph 12 of FAS 133, which describes the characteristics of an embedded derivative that would cause it to be bifurcated. The Board also discussed including applicable language in the amendment to FAS 140.

The Board reviewed four approaches for revised treatment of beneficial interests, eliminating two of them from the start. First off, FASB rejected Alternative No.1, which would specify that beneficial interests in a securitization be permanently exempt from FAS 133 (what one member labeled the "status quo").

The Board also eliminated Alternative No. 2: to develop a new framework of FAS 133's scope differentiating between the cashflows securitized and the cashflows of the beneficial interests. Alternative No. 3 provided that interests be accounted for as available-for-sale, whereby unrealized gains and losses are excluded from earnings.

The Board expressed most interest in a modified Alternative No. 4., where beneficial interests are classified as trading securities under Statement 115, with the election to bifurcate embedded derivatives and account for them under applicable GAAP, presumably FAS 133 for derivatives, sources said. When classified as trading, unrealized gains or losses are included in earnings.

Also at issue is whether to differentiate between beneficial interests in qualifying and non-qualifying SPEs. Since 2002, several proposals to replace D1 have been introduced. Issue D2, which proposed bifurcating a beneficial interest in a securitization into derivative and non-derivative portions, was previously deemed impractical in application.

"This situation has actually resulted in form dictating accounting rather than substance at times, and has result in similar transactions being accounted for in different manners," said Eric Smith, a FASB staff member assigned to the project. "One concern is that a derivative that might have been recognized under FAS 133 may not be recognized once true sale has occurred through a securitization."

The staff will prepare the issue for subsequent discussion at a future date.

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