by Marty Rosenblatt, Deloitte & Touche LLP
August 7, 2000
[Martin Rosenblatt, a renowned expert on accounting issues in securitization transactions, has been a regular contributor to this site. For other articles by Martin Rosenblatt, see our articles section. Martin can be contacted at mrosenblatt@dttus.com]
EITF 99-20 sets forth the rules (effective in the first quarter of 2001) for (1) recognizing interest income (including amortization of premium or discount) on (a)all credit-sensitive mortgage and asset- backed securities and (b) certain prepayment-sensitive securities including agency IOs and (2) determining when these securities must be written down to fair value because of impairment. Existing GAAP did not provide guidance for securities whose cash flows change as a result of both prepayments and credit losses and, in some cases, interest rate resets.
Scope
EITF 99-20 adopts the "prospective method" for adjusting the level yield used to recognize interest income when estimates of future cash flows on the security either increase or decrease since the date of the last evaluation (typically quarterly).
The impairment provisions of 99-20 bring us much closer to a lower-of-amortized cost or fair value approach than existing GAAP. Effectively, two sets of books are maintained: one at amortized cost and one at fair value. If (1) fair value is less than amortized cost and (2) the estimated cash flows have decreased since the last estimate was made (other than as a result of an interest rate reset of a plain-vanilla floater), then you must write-down the security to fair value through earnings.
Securities covered by 99-20 include:
- All ABS, CDOs, CMBS and MBS that are not (1) guaranteed by the government, its agencies or guarantors of similar credit quality or (2) sufficiently collateralized to ensure that the possibility of credit loss is remote (minimum rating requirements for exclusion from 99-20 were not specified)
- All IOs, including agency IOs and any other premium securities where prepayments could cause the holder not to recover substantially all of their recorded investment.(Agency POs are excluded.)
The above securities are covered by 99-20 regardless of whether they are:
- Securities purchased by investors or securities retained by securitizers
- Fixed rate or floating rate securities
- Publicly-offered or privately-offered securities
- Securities classified as held-to-maturity or available-for-sale. If classified as trading, they are already being marked to market, but the interest income recognition portion of 99-20 applies if the holder is required to report interest income separately in their income statement pursuant to industry practice.
- Securities designated as notes, bonds, pass-throughs or participation certificates. Even trust certificates are covered if they possess the characteristics of debt rather than equity securities.
Determining Periodic Interest Income
As of the purchase date for investors or the securitization date for securitizers, you estimate the timing and amount of all future cash inflows from the security using assumptions that were used in determining fair value. The excess of those future cash flows over the initial investment (or allocated cost under FASB 125 for securitizers) is the accretable yield to be recognized as interest income over the life of the investment using the effective yield method.
You determine the yield by solving for the internal rate of return (IRR) which equates those future cash flows back to amount of the initial investment. At any balance sheet date, the amortized cost of the investment is equal to (1) the initial investment plus (2) the yield accreted to date less (3) all cash received to date regardless of whether labeled as interest or principal less (4) any writedowns for impairment (see below).
You must update the cash flow estimates throughout the life of the investment taking into account the actual cash flow received to date and assumptions that marketplace participants would use in determining fair value. To determine the level yield used to accrete interest income in the following period, you must solve for a new IRR which equates the new estimates of future cash flow back to the amortized cost amount at the latest balance sheet date.
Determining Whether an Impairment Charge is Required
Whenever the current fair value of the security is lower than its current amortized cost, you must test to see if an impairment charge is required to be taken through current earnings. If your updated estimate of cash flows is less than your last revised estimate (taking into account both timing and amounts), then you must write the security down to fair value, which becomes the new amortized cost basis for future amortization. Decreases in cash flows resulting from resets on floating rate securities are not taken into account in this test provided the security is not a super-floater or an inverse floater.
Transition
EITF 99-20 must be applied starting in the first quarter of 2001, (regardless of a company's fiscal year-end) to all securities in the portfolio not just those purchased after 12/31/00. Earlier application is permitted but previously issued financial statements can not be restated to adopt the provisions of 99-20.
For the first quarter of 2001, the level yield to be used to recognize interest income will be based on the amortized cost amount at 12/31/00 and the estimates of future cash flows made as of 1/01/01.
For securities whose fair value is below amortized cost but no impairment charge was required to be recorded under existing GAAP, but would have been required if the company had been applying 99-20, an impairment charge writing the security down to fair value must be recognized in the first quarter of 2001 (may be recognized earlier) in a manner similar to a cumulative effect of a change in accounting principle.
Example of Application of EITF 99-20
- I purchase a B-piece on January 1, 2001 for $106.08. It has a face amount of $100 and is also entitled to all of the excess interest from the net coupon on the loans over the interest paid to the senior class, subject to reimbursing the senior class for credit losses.
- The assumed pre-tax yield at the date of purchase is 10.77% per annum based on an assumed prepayment rate of 5 CPR and assumed losses of 100 basis points per annum on the outstanding principal amount of the loans( the "Base Case").
- As of the end of year 1, there are five alternative scenarios presented in the table below. The first is that the base case prepayment, loss and market yield for the B-piece assumptions do not change. The other scenarios involve an increase or decrease in one or more of the assumptions as to prepayments, losses and market yield for the B-piece.
|
|
|
BASE CASE |
scenarios for Years 2 through 5 |
|||
|
|
|
ONE |
TWO |
THREE |
FOUR |
|
|
1 |
Prepayment Assumption |
5 CPR |
7 CPR |
7 CPR |
3 CPR |
3 CPR |
|
2 |
Credit Loss Assumption |
100 bp |
200 bp |
200 bp |
50 bp |
50 bp |
|
3 |
Market Yield for B-piece |
10.77% |
12% |
8% |
12% |
8% |
|
4 |
Cash Flows to B-piece: |
|
|
|
|
|
|
5 |
Year 1 |
$15.70 |
$15.70 |
$15.70 |
$15.70 |
$15.70 |
|
6 |
Year 2 |
13.30 |
11.19 |
11.19 |
14.34 |
14.34 |
|
7 |
Year 3 |
28.08 |
31.70 |
31.70 |
24.51 |
24.51 |
|
8 |
Year 4 |
52.23 |
49.24 |
49.24 |
54.44 |
54.44 |
|
9 |
Year 5 |
42.89 |
38.52 |
38.52 |
46.65 |
46.65 |
|
10 |
Total Years 1 thru 5 |
$152.20 |
$146.35 |
$146.35 |
$155.64 |
$155.64 |
|
11 |
Total Years 2 thru 5 |
$136.50 |
$130.65 |
$130.65 |
$139.94 |
$139.94 |
|
12 |
Fair Value at End Year 1 |
$101.80 |
$94.79 |
$104.94 |
$100.74 |
$111.80 |
|
13 |
Interest Income-Year 1 |
$11.43 |
$11.43 |
$11.43 |
$11.43 |
$11.43 |
|
14 |
Amortized Cost-end of Yr. 1 |
$101.80 |
$101.80 |
$101.80 |
$101.80 |
$101.80 |
|
15 |
Has there been a decrease in cash flows? |
NA |
YES |
YES |
NO |
NO |
|
16 |
Is Fair Value below Amortized Cost? |
NO |
YES |
NO |
YES |
NO |
|
17 |
Impairment to be Recorded? |
NO |
$7.01 |
NO |
NO |
NO |
|
18 |
Revised Yield for Year 2 |
10.77% |
12% |
9.17% |
11.59% |
11.59% |
|
19 |
Interest Income- Year 2 |
$10.96 |
$11.38 |
$9.34 |
$11.80 |
$11.80 |
Line 12 equals the pv of lines 6 through 9 discounted at the rate in line 3
Line 13 equals the initial investment of $106.08 times the base case yield
Line 14 equals the initial investment plus line 13 minus line 5
Line 17 scenario one is line 14 minus line 12
Line 18 equals the IRR of lines 6 through 9 discounted back to line 14 or in the case of scenario one back to line 12
Line 19 equals line 18 times line 14 or in the case of scenario one, line 12
The deal structure used to generate the cash flows was a pool of five year loans with a principal amount of $250 amortizing with five annual payments of $50. Gross coupon of 12% less 1% servicing fee. The senior class had a principal amount of $150, an interest rate of 6 %, and was entitled to 100% of all scheduled and unscheduled principal payments and write-offs of principal.
* EITF Issue 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets was completed at the July 19-20 EITF meeting. No further discussions are planned. This synopsis is not a substitute for a careful reading of the entire Issues Summary and consensuses, which contain additional provisions, particularly as to scope. A copy can be obtained by e-mail from mrosenblatt@dttus.com