New Treatment for Passive Derivatives

FASB is planning a revision to FAS 140 to eliminate a requirement that many finance executives have found troublesome.
Ed ZwirnJune 20, 2005

An exposure draft to be issued in August by the Financial Accounting Standards Board would do away with the requirement under FAS 140 that many syndicated loans and collateralized mortgage-backed securities be treated as investments for accounting purposes.

The revision would eliminate paragraph 40 of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. Under the current version, financial institutions that transfer part of the balance of loans containing embedded derivatives to qualifying “bankruptcy remote” special-purpose entities are required to keep the entire balance on their books until all is settled.

According to FASB project manager Patricia Donaghue, all seven board members approved the elimination of paragraph 40 at last Wednesday’s meeting. The removal of that paragraph was necessitated by other FASB rulings that will force the transferor to put all of the assets in question into a particular qualified special-purpose entity, says Donaghue.

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The August exposure draft will be subject to a 60-day comment period.

In February, mortgage lender Countrywide Financial fell afoul of paragraph 40 when it issued a restatement of its 2004 financial results. The company, which had recorded a gain on the sale of a special mortgage-backed security that contained an embedded interest-rate security, was found by its auditor, KPMG, to have misread the standard by recognizing the gain on the sale of these securities even though the entire portfolio of securities had not been sold.

The revision, which amounted to 20 cents per share of net earnings, also forced Countrywide to disclose a material weakness in its internal controls in its 2004 annual report.

Washington Mutual Bank deputy controller Larry Gee says his company was particularly concerned with clarification of the paragraph 40 requirements for banks that securitize commercial loans by transferring them back and forth with broker-dealers. He also defended Countrywide’s practice (followed by many other lenders) of spreading the risk of loans by selling off pieces through a syndication. If the syndication is “not considered a sale [of] a secured borrowing,” observes Gee, the bank has to “keep the big loan on its books.”

Similar concerns have been voiced by organizations including KPMG, the American Securitization Forum of the Bond Market Association, and lobbying group the Real Estate Roundtable. In a 2003 comment letter to FASB, the roundtable warned that the paragraph 40 restrictions “could have the unintended consequence of diminishing the liquidity of an otherwise robust $360 billion U.S. commercialized mortgage-backed securities market.” They might also “impede the flow of credit to the commercial real estate sector and, thereby, affect its overall liquidity and valuation,” the letter added.

Gee, who is also a member of the Financial Institutions Accounting Committee of the Financial Managers Society, adds that the committee — which had long been critical of the paragraph 40 restrictions — was pleased with FASB’s recent decision.

When FAS 140 was first implemented, FASB members “were afraid companies would try to hide derivatives,” explains Gee. “But in the case of passive derivatives, companies do not have anything to manage. There is usually a strike price, and you’re either in the money or out of the money.”

In other business, last week FASB circulated a draft of proposed staff position FIN 45-b, regarding minimum revenue guarantees. For the guarantor, the proposal would tighten the accounting treatment of a guarantee granted to a business or its owners.

For example, suggested the draft, a corporation (the guarantor) that wished a day-care center (the guaranteed party) to locate nearby might agree to make monthly payments to the center to make up for any shortfall from a specified monthly amount. Likewise, a not-for-profit health-care facility that recruited a physician to establish a practice nearby might make similar payments if the physician’s gross receipts failed to attain a specified threshold.

The new staff position would be effective for all minimum revenue guarantees issued on or after the beginning of a guarantor’s first fiscal quarter after the final version of FIN 45-b is posted on the FASB website. Comments are due August 8.

Looking ahead this week, the board will meet in an abbreviated session Wednesday afternoon to continue its discussion of the qualitative characteristics of accounting information. The discussion will center on certain characteristics identified in the current framework, such as comparability, understandability, and materiality, as well as whether to add other possible qualitative characteristics, such as transparency and “true and fair.”