Collateralized Mortgage Obligations (CMOs)

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ISSUE NO. 89-4

CMOs are created by segregating mortgage collateral (such as Ginnie Maes and mortgage loans) into a pool and selling bonds whose principal and interest will be paid from the colateral payments and reinvestment income.

Regardless of legal form, some CMOs have characteristics of debt instruments. They have stated principal amounts and interested rates.

Other CMOs have equity characteristics. Purchasers of these CMOs are entitled to the issuer's excess cash flows from the mortgage collateral over the amounts required for debt service and administrative expenses.

The task force considered three accounting issues for a purchased investment in a CMO. They are:

1. Which factors should be considered to determine whether to account for CMOs as equity or nonequity? Should they be its legal form, economic substance or other factors?

2. What common attributes of nonequity high-risk CMOs distinguish them as a group of instruments that should be accounted for in a similar manner?

3. How should an investment in a nonequity CMO be accounted for in subsequent periods? How should the cash flows be allocated between income and return on investment?

Consensus. The EITF considered these issues at seven task force meetings during the past year. It also appointed a working group, a rare move for the EITF, to recommend possible solutions. Finally, at the May 31, 1990, meeting, the task force reached the following consensuses:

Issue no. 1. The task force decided the accounting for a purchased investment in a CMO generally should follow its form. However, if all of the following criteria are met, the equity CMO (in form) should be accounted for as a nonequity instrument:

* The issuer's assets didn't come from the CMO purchaser.

* The issuer's assets consist of only high-credit-quality monetary assets for which prepayments are both probable and their timing and amounts are reasonably estimable.

* The issuer is self-liquidating. That means the issuer will terminate when its existing assets and liabilities are collected and paid.

* Assets collateralizing the issuer's obligations may not be exchanged, sold or otherwise managed as a portfolio. Also, the purchaser may not substitute assets that collateralize the issuer's obligations.

* There's no more than a remote chance the purchaser would need to pay for the issuer's administrative or other expenses.

* No other obligee of the issuer has recourse to the buyer of the investment.

Provided these criteria are met, the ability of the purchaser of a CMO to call other CMOs of the issuer generally will not preclude accounting for the investment as nonequity.

CMOs issued in equity form that don't meet these criteria should follow the accounting in Accounting Principles Board Opinion no. 18, The Equity Method of Accounting for Investments in Common Stock, or Accounting Research Bulletin no. 51, Consolidated Financial Statements, as amended by FASB Statement no. 94, Consolidation of all Majority-Owned Subsidiaries.

Issue no 2. The task force decided nonequity CMOs that have the potential for loss of a significant part of the original investment because of changes in (1) interest rates, (2) the prepayment rate or (3) reinvestment earnings are high risk and should be accounted for similarly.

CMOs that don't have the potential for loss of a significant part of the original investment, such as principal-only certificates, would not be considered high-risk CMOs. If these CMOs are bought, any premiums or discounts should be amortized in accordance with FASB Statement no. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.

Issue no 3. …