FASB Expands Use of Fair Value for Securitized Assets

Not only did the FASB just expand the fair value option for securitized assets, but the Board added further pressure on reporting entities to use fair value. Entities that elect the fair value option are allowed to skip a complex and time-consuming bifurcation analysis of certain embedded credit derivative features. The new rule applies to embedded credit derivatives in beneficial interests in securitized financial assets that are not already reported at fair value through earnings, such as those classified in held-to-maturity and available-for-sale. Prior to the new rule, there was a scope exception that was widely interpreted to mean that any credit derivative feature associated with a contract that transferred credit risk could bypass the otherwise-required bifurcation analysis. The new rule reduces the number of embedded derivatives that qualify for the exception – yet it also provides reporting entities with an “out”: elect fair value and bifurcation is no longer required. If you are an investor in contracts that involve the transfer of credit risk or a seller of credit derivatives, you need to understand this new rule to decide whether or not to elect the fair value option and ensure compliance with the new disclosure requirements. SUMMARY The FASB recently issued Accounting Standards Update 2010-11, Scope Exception Related to Embedded Credit Derivatives (ASU 2010-11), which deals with credit derivatives embedded in securitized financial assets. Examples of securitized financial assets include asset backed securities, credit-linked notes, collateralized loan obligations (CLOs), and collateralized debt obligations (CDOs). After the effectiveness of ASU 2010-11, the scope exception only applies to situations involving the transfer of credit risk between tranches resulting solely from the process of subordination from one tranche to another. All other embedded derivatives must be evaluated for bifurcation, including derivatives related to interest rate risk and credit risk (other than from subordination). A bifurcation analysis must include whether the embedded feature or provision meets the definition of a derivative, whether it is clearly-and-closely-related to the host contract, and how to value the feature or provision by itself. In lieu of such an-depth analysis, companies may now elect to fair value any beneficial interest in securitized financial assets. The fair value election option is described in more detail below under "Implementation". In addition to narrowing the scope exception as outlined above, and providing the new fair value option, the new rule also makes the following changes in accounting practice:

1. Companies are required to disclose the gross gains and losses that make up any cumulative effect adjustment to retained earnings.
2. An interest in a tranche of securitized financial instruments that may require the holder of the interest to make future payments would not qualify for the scope exception.
3. The disclosure requirements for sellers of credit derivatives will apply to all embedded credit derivatives within beneficial interests in securitized financial assets (except those resulting solely from subordination).

Beneficial interests in synthetic CDOs will explicitly require either bifurcation or the election of the fair value option. IMPLEMENTATION Upon adoption, companies are allowed to elect the fair value option for any beneficial interest in securitized financial assets. The election can be made on an instrument-by-instrument basis. Please note, companies should document their accounting positions at the date of adoption. If the fair value option is elected, a bifurcation analysis is not required. All cumulative unrealized gains and losses should be reported as a cumulative-effect adjustment to beginning retained earnings. This applies to both held-to-maturity and available-for-sale investments (which should also be tested for impairment prior to adoption). If the fair value option is not elected, a bifurcation evaluation is required. The carrying amount of the host contract on the date of adoption should be based on a pro forma bifurcation (1) as of the date of the entire hybrid instrument’s inception and (2) the host contract’s accounting treatment subsequent to the date of adoption. On the date of adoption, any difference between the carrying amount of the hybrid instrument before and after bifurcation is recognized as a cumulative effect adjustment to beginning retained earnings. The two cumulative-effect adjustments described above could be completely different from one another since one involves the fair value election related to the entire instrument whereas the other involves bifurcation and valuation of an embedded derivative. EFFECTIVE DATE Companies must adopt ASU 2010-11 by the first day of the first fiscal quarter beginning after June 15, 2010. Early adoption is permitted. CONCLUSION We expect more financial instruments to be accounted for at fair value through earnings under the new rule. In particular, we believe this change will affect financial institutions. Unless the fair value option is elected, companies must perform a bifurcation analysis for any embedded derivative that no longer meets the scope exception. We expect many reporting units to seek to avoid the complexities of defining and fair valuing bifurcated embedded derivatives by electing the fair value option on an instrument-by-instrument basis. If you would like to explore further how Pluris can assist you in your fair value elections and in testing securities for impairment prior to adoption, we invite you to contact us at 212.248.4500 in New York or 650.485.4049 in California, or to email us at [email protected].