The Financial Accounting Standards Board (FASB) lifted a huge burden from MBS and ABS investors’ shoulders last week by exempting those bonds from mark to market accounting requirements under FAS 155. Industry participants were concerned that FAS 155 contained accounting implications that would affect market liquidity and spreads for those securities.
Last week, the FASB voted 6-1 to approve an exception for ABS and MBS in tests for FAS 155, which govern accounting for certain hybrid financial instruments. The accounting rule required investors to perform tests on ABS and MBS to determine if they contained embedded derivatives as defined by FAS 133, the previous version of the rule. If the securities met those tests, then companies might have been required to apply mark to market accounting on prepayable MBS and ABS purchased at a discount, or apply mark to market on the embedded derivatives in the securities.
Both options spooked MBS and ABS investors, which include banks, insurance companies, thrifts and GSEs. For those investors, it might have resulted in accounting volatility on the securities, possibly resulting in weakened demand and liquidity for them.
FAS 155 calls for two tests, a Lehman Brothers report explained. The one that concerned investors the most, the so-called double-double, says if an embedded derivative could result in a rate of return on the security that is double the initial rate of return on the main contract, that derivative could be considered an embedded derivative for accounting purposes.
“This test would have been extremely severe on discount ABS/MBS securities,” wrote Lehman analysts. “Extremely fast prepayments could result in a doubling of expected return on many discount bonds.”
The FASB exempted certain ABS and MBS deals from the test if they would only qualify as having an embedded derivative because of prepayment risk of the underlying prepayable assets. It would also be exempt if the investor could not exercise the right to accelerate the settlement of the securitized interest.
Any MBS that is purchased at par or discount, which does not have any other embedded interest-rate related derivative or leverage, pass throughs, sequentials and most companion bonds, would be exempt from tests for mark to market accounting under FAS 155, explained Marty Rosenblatt, the founding partner of the securitization practice at Deloitte & Touche, during a Bear Stearns conference call after the FASB board meeting last week.
On the other hand, certain securities that are more complex and have other embedded derivatives – such as inverse floaters and interest-only leverage floaters – would not be exempt from the test of bifurcation and would be subject to accounting rules under FAS 155.
The exceptions did not solve all puzzles related to interest rate risks, noted Steven Abrahams, a Bear Stearns market analyst who moderated the bank’s conference call on the issue last week. Particularly, some market players were confused about whether exemptions might apply to interest-only and principal-only strips. To that, Rosenblatt said that I/Os derived by simply separating interest flows from principal flows would be exempt, provided that no guarantee fees are being stripped from the assets.
Although the ABS and MBS markets succeeded in getting relief from FASB on this issue, board members indicated that they should not push their luck. The board’s decision last week is only preliminary. The FASB will issue its recommendation in the form of a draft Statement 133 Implementation issue for a 30-day comment period, which should end in mid-December. At the end of that comment period, the FASB could substantially revise FAS 155 before implementation in January 2007. Even so, Rosenblatt said during the Bear Stearns call, companies that began implementing FAS 155 earlier than last January can most likely rely on the revisions to adjust their financial statements as necessary.
One board member, who did not object to FAS 155 going forward in its current form, asked the staff members to commit to the current revisions, and not to ask for more exceptions because the industry found the rules to be unpopular, said one market source.
“The staff acknowledges that this recommendation provides a broad scope exception for a prepayment risk,” said Jason Jacobs, a practice fellow at FASB and senior staff member in charge of the project, during its board meeting last week. “However, it does not, and is not intended to, provide blanket scope exception for all interest rate risks.”
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