Mortgage-Backed Securities and Fair-Value Accounting

Article excerpt

Many entities are in the process of implementing FASB's recently issued guidance on fair value, SFAS 157, Fair Value Measurements, and SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115. Proper implementation can require CPAs to exercise professional judgment This professional judgment is being put to the test in the measurement of fair value for mortgage-backed securities (MBS) because of significant declines in values and reduced levels of trades resulting from the recent credit market crises. This article illustrates the application of this professional judgment to MBSs as well as a discussion on otherthan-temporary impairments of MBSs under SFAS 115, Accounting for Certain Investments in Debt and Equity securities. In addition to providing a primer on the accounting treatment of MBSs, the discussion of SFAS 157 and SFAS 159 is expanded to help CPAs apply these standards in other situations.

Mortgage-Backed securities Primer

The Office of Federal Housing Enterprise Oversight (OFHEO), an independent entity within the U.S. Department of Housing and Urban Development, defines an MBS as "a security that represents an undivided interest in a group of mortgages." (See "Portfolio Caps and Conforming Loan Limits," Mortgage Market Note 07-1, OFHEO, September 6, 2007.) Investors in these securities have the right to receive future mortgage payments (interest and/or principal). Payments on some MBSs are guaranteed by one of three agencies: the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae is associated with the federal government and its guarantee is backed by the full faith and credit of the government Thus, an MBS guaranteed by Ginnie Mae is considered a low credit risk. (Although Fannie Mae and Freddie Mac were established by the federal government, they are not government-funded.) MBSs backed by the guarantee of Fannie Mae and Freddie Mac are generally considered to be low risk.

Additional MBSs are issued by private entities and are not guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. Accordingly, these MBSs generally carry a greater credit risk than an MBS that has an agency guarantee. In recent years, the issuance of non-agency MBSs grew rapidly. For example, OFHEO estimates indicate that non-agency MBSs issued comprised 19.7% of all MBSs issued in 2001 and 55.9% in 2006 (table 1 in the aforementioned article "Portfolio Caps and Conforming Loan Limits"). In 2007, the trend started to reverse; in the second quarter of 2007, non-agency MBSs issued were 47.2% of the total MBSs issued.

The most common type of MBS is a pass-through security in which mortgages with similar characteristics are pooled together and each investor receives a prorata share of principal and interest. Other variations of MBSs include a collateralized mortgage obligation (CMO), which is formed when payments from a pool of mortgages are divided into different bond classes known as tranches. The distinguishing feature between the tranches is that each one represents a different maturity. For example, if a security has four tranches, payments are made to the bond class (tranche) with the shortest maturity. Once the entire principal is paid on this tranche, payments are made to the bond class with the next shortest maturity. The process continues until all tranches are paid.

Stripped MBSs are a special variation of a CMO. With a strip, the claim to the future principal and interest payments are separated into two classes. Owners of the interest-only strip have claims to the interest from the mortgage payments. Owners of the principal-only strip have claims to the principal from the mortgage payments. Interest paid on the interest-only strip is based on outstanding principal. Accordingly, interest-only strips have a greater prepayment risk than do other MBSs. …

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