A standard recently issued by the Financial Accounting Standards Board is expected to increase the volume of synthetic CDO issuance.
The new standard, FAS 155 - or "Accounting for Certain Hybrid Financial Instruments" - amends the regulations FAS 133 and FAS 140 and takes effect on Sept. 15. The development comes at a time when synthetic issuance is booming. CDOs are increasingly referencing credits synthetically, and the release of synthetic home equity ABS and commercial mortgage-backed securities indices are anticipated to trigger even more liquidity in the sector.
FASB's change aims to reduce the complexity involved with accounting for derivatives. The move is expected to improve the ease of accounting for financial instruments - such as CDOs - with embedded derivatives because it will allow the structures to be accounted for as a whole. Under current rules, derivatives must be split away and valued separately.
According to Bank of America Securities, the new standard means mark-to-market charges for synthetic CDOs can now avoid earnings and flow straight through to shareholder equity.
"Depending on the pace of adoption, this accounting change could meaningfully increase synthetic volume, helping to limit the scope of any overall spread widening, compress single-name and index CDS spreads, and potentially reduce equity tranche correlation," BofA wrote last week.
The new standard works to eliminate a previous restriction on the number of so-called passive derivative instruments, such as those found in synthetic CDOs, that a special purpose entity is allowed to hold. According to Deutsche Bank, that standard was initially in place to stop a SPE from holding a derivative that may not be accounted for as such by its beneficial interest holders.
Under the old standard, companies were forced to account separately for embedded derivatives. FASB did provide temporary guidelines to put off that evaluation process. However, those will be eliminated with the new standard. Under the new standard, synthetic CDO investors can choose to measure their investments at fair value, or mark-to-market value, at the time of acquisition, at issuance or when they are remeasured.
The new regulations require holders or issuers of the beneficial interests in a securitization to state interest as either standing or embedded. That change will cause interest to be accounted for using the fair value election process. The rules also clarifiy ambiguity in relation to reporting requirements for interest-only and principal-only strips.
"Investors, previously daunted by the evaluation and possible bifurcation process of hybrid synthetic instruments in the past, should find it easier to navigate the valuation process for accounting purposes," Deutsche wrote last week.
CDO issuance so far this year has surpassed $18 billion. In February, more than $11 billion in new CDO paper came to the market. Of that, about $1.2 billion came in the form of synthetic ABS CDOs, according to Deutsche.
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