The Financial Accounting Standards Board met this morning to discuss issues concerning the implementation of FAS 155. Specifically, how FAS 155 affects ABS/MBS and whether an exemption needs to be issued.
A Merrill Lynch report said that the focus of the meeting was on determining which ABS/MBS structures are subject to the double-double test, noting that this is only one of two tests that a bond must pass to avoid hybrid security accounting. The other test says that if an investor might not recover "substantially all" of his or her initial investment, then the bond is seen as a hybrid. All ABS/MBS are still subject to this test, but very few bonds will actually fail it, Merrill said.
The proposed scope exemption for securitizations that were approved by FASB (with one dissenting vote) include those that"only contain an embedded derivative that is tied to the prepayment risk of the underlying financial asset" as well as those where "the investor does not control the right to accelerate the settlement" was approved The proposed exemption will be issued with a 30 day comment period.
The implications of this exemption are clear. Most ABS/MBS that were initially thought to be subject to bifurcation will now be exempt, such as passthroughs, sequentials, PACs, and supports. Board members also cited uneven accounting treatment for similar instruments due solely to dollar price and the fact that only the debtor can invoke the prepay option as reasons for this exemption.
Certain ABS/MBS will still be subject to the double-double test because they are considered to have an interest-rate derivative not related to their prepay derivative. An example given of this was an inverse floater.
In terms of IOs/POs, these structured securities were not exempt under FAS 155. Structured POs failed the double-double test while structured IOs failed the "substantially all" test. Also under FAS 155, trust IOs and POs may have been given an exemption but it was not really clear.
Under the new guidance, IOs and POs won't be subject to the double-double test. This means they will only have to pass the "substantially all" test. Both structured and trust POs will pass the substantially all test, but IOs will not, Merrill said. Thus, structured IOs are probably not exempt and trust IOs may or may not be exempt since it is not clear if a trust IO off a mega/giant includes terms not included in the underlying debt instrument which is the criteria of the original FAS 155 exemption. This is one issue that probably still needs some guidance, Merrill said.
In terms of non-agencies, there was some concern that bonds that came after an embedded swap in a deal's waterfall would need to be tested for an embedded derivative. The scenario that would result in a bond failing the test would be a big prepay wave with rates falling significantly. Merrill said that under this environment, there would not be sufficient collateral interest income to make the net payment on the swap.
Because this scenario is sensitive to both interest rates and prepayments, nonagencies might not meet the first criteria above. However, Merrill reported that at the meeting, one FASB member said "just having an interest rate swap in the securitization shouldn't taint the instruments that come out." This implies that an embedded swap will not cause the bonds below it in the waterfall to fail the "substantially all" test.
