The Financial Accounting Standards Board’s plan to revise Financial Accounting Standard 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, received a push in February, when mortgage lender Countrywide Financial fell afoul of its provisions and was forced to issue a restatement of its 2004 financial results.
Last month, board members decided to revise paragraphs 40B and 40C of that standard to require that, in order to receive sales accounting treatment, a qualifying special purpose entity (QSPE) be subject to revenue recognition tests only at the time a deal involving derivative securities is made. That is, generally they would not be subject to ongoing tests.
This settled a major concern among issuers, holders, and servicers of mortgage-backed securities, which often see revenue streams dry up and fair value plummet when interest rates shift downward, prompting faster-than-expected prepayments of mortgages as borrowers seek to benefit from reduced rates.
On August 11, the board issued three closely related exposure drafts clarifying other issues concerning FAS 140 as well as Financial Accounting Standard 133, Accounting for Derivative Instruments and Hedging Activities. One of the three proposals relates to the accounting for servicing of financial assets; another relates to the accounting for hybrid financial instruments and would affect the accounting for beneficial interests in securitized financial assets issued by a QSPE. The third would permit fair-value measurement for any hybrid financial instrument containing an embedded derivative that otherwise would be required to be bifurcated into its individual components, permitting them to be marked to market.
The provisions of the drafts, for which the comment periods end October 10, are effective for instruments acquired after December 15. So far, the industry reaction seems to be positive.
“I think what’s in there was for the most part what we expected,” says Ernst & Young partner David Thrope, co-chair of the Commercial Mortgage Securities Association’s FASB Monitoring Committee. Thrope points out that while the derivatives accompanying mortgage-backed securities often use the direction of key Treasury rates as a benchmark “to hedge what happens if interest rates go down,” the benchmark and the prepayment behavior don’t always work in sync. The revisions would help servicers by allowing them the option of marking their servicing rights to market, he notes, so financial institutions could use unrealized gains to offset prepayment losses.
Another provision requires a bank or other servicer of a mortgage-backed security portfolio to employ an independent fiduciary entity to make the rollover decisions that take place in a QSPE, usually at 30-, 60-, and 90-day intervals. Much detail work on this provision, which requires an arms-length relationship between the servicer and the fiduciary, remains to be done, according to Thrope.
This Wednesday, the board will meet for a further discussion of its GAAP hierarchy project. Looking farther ahead, FASB will hold a public roundtable on October 10 to discuss its proposed interpretation, Accounting for Uncertain Tax Positions, which applies to Statement No. 109, Accounting for Income Taxes. The proposal requires that in order for a company to recognize a tax break in its financial statements, it must meet a “probable recognition threshold” — that is, the company must have a high degree of confidence that the tax break “will be sustained upon audit by a taxing authority.”