Earlier this year, the Financial Accounting Standards Board released FAS 155, Accounting for Certain Hybrid Financial Instruments. This was an update to the earlier FASB pronouncements (Statements No. 133 and 140) dealing with the accounting treatment of certain derivatives embedded in other financial instruments or hybrids The major change from the earlier statements is the lifting of an exemption for structured MBS. The accounting ramifications now flow through directly to the income statement, which will start on Sept. 15 for fiscal year companies and Jan.1, 2007 for calendar year companies. Anything done previously will be grandfathered in and not applied against 155.

This new standard has not been well received by the Street as a whole. The potential effects on the structured mortgage market - CMOs, MBS, ABS, and CMBS - have many participants concerned. Any structured bond with a perceived "disproportionate" cash flow is subject to these un-exempted accounting rules and treatments, with CMOs particularly highlighted in most dealer research available.

Embedded derivative?

Previously, FAS Nos. 115 & 133 required securitized financial assets defined as either "held to maturity" or "available for sale", and any changes were reported to and flowed through to "other comprehensive income." Currently, under FAS 155 as it currently stands, a determination will have to be made by the investor to see if the securitized financial instrument has an "embedded derivative". If it does, then the "hybrid" would be "bifurcated," with any resulting change (from the previous carrying amount) listed on the income statement. This is a potentially damaging event to banks and insurance companies that continually need steady and consistent earnings reports.

Two terms and procedures need to be explained before proceeding further. The first concept is bifurcation, which is the accounting procedure of separately valuing and listing the host contract - typically in CMOs, that would be the collateral underlying the cash flows, i.e. FNMA 5% -from the embedded derivative (typically, the non host portion, the CMO tranche itself, such as the PAC or the Sequential). Any change in value versus the carrying amount will then be separately listed on the income statement of the purchaser.

There is also the double/double test, which is part of a three-pronged hybrid determination. This three-pronged determination includes, recovering "substantially all" of the initial recorded investment (greater than 90%) upon settlement. Securities with a value greater than $111 would probably fail this hurdle as well as an interest rate scenario where the embedded derivative would at least double the investor's return ("double/double"). Deeply discounted CMO PACs and SEQs would fail this if set to an extreme down 300 basis points test and an interest rate scenario where if the host contract doubles the rate of return, then the embedded derivative must, at the same time, have to at least double the rate of return.

Meeting (failing) any one of the three tests would qualify that financial instrument as a hybrid and require bifurcation in the accounting treatment.

The entity is allowed to make a one time, irrevocable election to value individual items at fair value (mark to market), thereby avoiding bifurcation. FASB is striving to establish this as the standard bearer. Much of the language in the Board's minutes point unquestionably in this direction. Globally, the International Accounting Standards Board uses the fair value treatment.

Treatment of other financial instruments

The remaining directives deal with concepts such as "comparability" and "consistency." The test of the other parts of FAS 155, are centered on "proportionate distribution" of cash flows, where "disproportionate distribution" is singled out for bifurcation (as originally stated in FAS 133). Passthrough securities would, therefore, not require further bifurcation as they are viewed as "proportionately" distributed cash flows. In cases where the allocation gets "disproportionate", such as guaranteed servicer fees, then they would lose the exemption.

Strips are viewed along the same basic guidelines. Trust IOs and POs are taken at their simplest form, generically "proportionate" cash flows of either principle or interest, where the inherent values (of being a principle or interest only vehicle) are already accounted for. Subordinate bonds are viewed as "effectively allocating credit risk" and are exempt from bifurcation. Their credit risk is already seen as reflected in their value, and requires no further recognition.

Finally, any bond where the "debtor (issuer/borrower)" holds the call option effectively exempts the financial instrument from the test. This is seen to include callable debt and freely pre-payable commercial loans (post lock period). Depending on the cash flow and or call structure, these guidelines can be applied to ABS, CMBS and any other financial instrument that has an embedded call.

The consensus seems to read that if applied to the markets as currently written, FAS 155 may weaken demand for structured paper and that may very well widen spreads.

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

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