Point of View: FAS 133 Complications
Mr. Kempner is president and chief executive officer of the Mortgage Bankers Association. This viewpoint is an excerpt from a comment letter the MBA sent to the Financial Accounting Standards Board. The text of the full letter can be found on the MBA's website.
The Mortgage Bankers Association is very concerned that some issuers, investors and others believe the guidance in FAS 133, as amended by FAS 155, requires "plain vanilla" pass-through mortgage-backed securities to be evaluated under paragraph 13.b of that statement. MBA believes the application of that paragraph to certain discounted pass-through MBS would have an unexpected, chilling effect on the market by reducing the demand for MBS by investors that do not want to undertake the challenge of having to bifurcate a derivate in some inexplicable way or, alternatively, of recognizing the earnings volatility occasioned by temporary fluctuations in interest rates.
MBA has reviewed FAS 133 and all related literature and believes it supports our position that pass-through MBS are not required to be evaluated under paragraph 13.b for the reasons explained below.
In drafting FAS 133, the board cited "prepayable mortgages" as examples of compound instruments with embedded derivatives that are "clearly and closely related" to their mortgage host contracts. The fact that the board singled out prepayable mortgages for identification and discussion to illustrate the "clearly and closely related" language in FAS 133 suggests that the relationship of the embedded prepayment option and the mortgages is so well established and understood that there would be no need to apply the quantitative tests in paragraph 13 to the instrument to prove the point. Consequently, MBA believes the guidance in paragraph 13, and 13.b in particular, was developed by the board with other hybrid instruments in mind; namely, structured finance transactions involving specifically negotiated terms and conditions designed to appeal to investors' objectives.
By contrast, the prepayment option in mortgages is intended to accommodate borrowers' needs, rather than investors' desires.
MBA believes industry practice reflects a broad based understanding that the embedded prepayment options in loans and MBS meet the "clearly and closely" related test in paragraph 12 without the need to evaluate them under 12.b. This is because no lenders, to MBA's knowledge, have ever bifurcated those instruments, regardless of whether they believed they were subject to the exclusions provided for in FAS 133 Implementation Issue D1.
Moreover, the guidance in FAS 134, which was released after FAS 133, appears to sanction this treatment by giving holders that are mortgage banking companies the opportunity to classify their MBS as other than "trading" securities, with no mention of the need for holders to evaluate them under 13.b if they are not so classified.
MBA understands that some people believe the staff's comments require pass-through MBS to be evaluated under paragraph 13.b because some amount of the mortgage interest payments is used to pay a guarantee fee and/or a servicing fee ("in excess of adequate compensation") which renders allocations of cash payments "disproportionate" as that word is described in paragraph 4.a of FAS 155.
MBA believes this interpretation, however, overlooks the specific wording of the staff's comments, which refers to cash flows associated with the embedded call feature only, rather than to scheduled mortgage payments. Considered in the context of pass-through MBS, the accelerated principal payment under the call feature would be distributed proportionately because the repaid principal would be allocated to investors without reduction for any guarantee or servicing fees.
In conclusion, MBA believes that the current FAS 133, as amended by FAS 155 and interpreted by B39 and B16, does not require pass-through MBS to be evaluated under paragraph 13.b. However, to ensure that issuers and holders have a common understanding for the requirements of the statement, MBA recommends that the board confirm as soon as possible that B39 does not require pass-through MBS to be evaluated under paragraph 13.b because some companies that have already adopted FAS 155 are preparing to file their third quarter financial statements and need confirmation that MBA's interpretation, which is consistent with their interpretations, is correct. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com