The Financial Accounting Standards Board has amended earlier statements, Nos. 133 and 140, with a recently issued one, No. 155, that addresses the accounting treatment for hybrid financial instruments that contain derivatives.

The latest statement, published this month, repeals the temporary guidelines under which companies have been operating since 2000.

The market had applied the interim rules in Derivatives Implementation Group Issue No. D1. FASB recognized the difficulties of separating out embedded derivatives into distinct components from debt instruments for securitizations. It had allowed firms to treat these hybrids as one instrument, essentially deferring the task of that evaluation. The 2000 guidelines carved out exemptions for interest-only and principal-only strips.

However, "it was not always clear which POs and IOs were actually exempt," said Lisa Filomia-Aktas, partner and practice leader on-call at Ernst & Young LLP.

No more free pass'

FAS 155 requires holders of these instruments, such as investors in CDOs, to evaluate whether the instruments require separate accounting by examining the cash flows, payoff structures and payment priorities of the instrument. That means the holders have lost their "free pass," according to Jeffrey Allen, a managing director at PricewaterhouseCoopers. The bad news is that "the investigation cannot be shelved any more, and you can no longer hide behind the D1 exemption," Allen said.

FASB has clarified that the exemption pertaining to IO and PO strips is narrow.

"From now on, only the plainest vanilla versions will be permissible, nothing elaborate," said Mark Adelson, director-head of structured finance research at Nomura.

The good news is that "FASB has now provided an election, or option, to make it a little easier," Filomia-Aktas said.

If a derivative must be separated from its host contract, the owner can measure the hybrid instrument in one piece, as long as it does so on a fair value (mark-to-market) basis.

"It saves nuisance," Adelson said. "More companies will probably have an appetite for instruments that otherwise would have triggered bifurcation."

It is helpful to consider examples to illustrate what might and might not be subject to bifurcation.

Consider an entity that issues fixed-rate assets such as mortgages. Suppose the entity issues two classes of securitized instruments, one consisting of notes payable at Libor plus 10 basis points, and a residual asset entitled to the remainder. Does the residual have an embedded derivative? The answer is yes, and for two reasons. First, it is at risk for movement in Libor, which meets the definition of a derivative, and second, the derivative is not clearly and closely related to the host. The analysis considers the structure as a whole and takes into account the related liabilities. In this case, the subordinated holder might not recover its initial investment if there is an adverse move in interest rates. If all the assets and liabilities of the issuing entity were tied to a Libor rate, the remainder would probably not be embedded.

Filomia-Aktas offers another example of a securitization that introduces new credit risk. She postulates a special purpose entity that writes credit default swaps that expose it to the risks of Company A, and issues notes that expose the holders of the notes to the risk of that same Company A. In that case, no bifurcation is called for, "as long as the risk is based on the creditworthiness of the issuer," Filomia-Aktas said. If, however, the notes reference Company B instead of Company A, the entity may have created an embedded derivative. Now the purchaser is vulnerable to the risk of a third party.

"These are probably extreme cases," Allen said. "More often, structures are calibrated so that assets pay down while a derivative amortizes. Most investors, who do not want their returns squeezed, would insist that the original transactions are modified to contain risks."

Fair value reporting

FASB has allowed holders of hybrids to continue to measure them as one piece while it imposes an election for fair value reporting.

Jason Kravitt, a partner at Mayer Brown Rowe & Maw, places this stipulation in a larger context.

"It belongs to a broader trend of converting financial reporting, whenever possible, to a mark-to-market system," he said.

All parties may not be enthusiastic about fair value reporting.

"Some people would prefer not to mark-to-market," said David Thrope, a partner at Ernst & Young LLP. "It can create volatility on the balance sheet, which flows through to the income statement."

Holders of hybrids must make their election as to whether to bifurcate all instruments acquired, issued or subject to remeasurement at the beginning of their own fiscal year following Sept. 15, 2006.

Allen does not expect the new regulation to provoke dramatic changes in most investors' accounting practices, as relatively few have embedded derivatives to contend with. As for those who do, Kravitt does not foresee any decline in activity.

"Any rule that simplifies this area is desirable. The complications have been so great that they got in the way of doing transactions," he said.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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