MORTGAGE-BACKED SECURITIES This month's column discusses a consensus reached at a recent meeting of the FASB emerging issues task force (EITF or task force) concerning exchange transactions involving mortgage-backed securities. A FASB staff response on a debt classification question also is presented.
EITF Abstracts, copyrighted by the FASB, is available in softcover and loose-leaf versions and may be obtained by contacting the FASB order department at 401 Merritt 7, PO. Box 5116, Norwalk, Connecticut 06856-5116. Phone: (203) 84 7-0700. ISSUE NO. 90-2
This issue, Exchange of InterestOnly and Pyincipal-Only Securities for a Mortgage-Backed Security, concerns exchange transactions involving mortgage-backed securities.
A mortgage-backed security (MBS) is a participation in a pool of residential mortgages (such as GNMAs and FNMAS). A pool of mortgages with common characteristics (such as 30-year fixed-rate mortgages on single-family residences) is put into a trust and sold to investors.
The cash flows from a mortgage backed security may be stripped and sold to investors separately as interest-only (I/0) securities or as principal-only (P/0) securities. Ownership of an I/O and P/0 security means the investor owns a share of the interest and principal payments, respectively, on the underlying security.
The facts. The task force considered these facts: An investor owns an I/O and P/0 security from different trusts or an investor owns only an 1/0 or a P/0 security. The security is carried on the books at amortized cost.
The investor (1) exchanges either the I/0 or P/O/ with an independent third party, or (2) purchases an I/0 or P/0 security from a third party so the investor now owns an I/0 or P/0 security from the same trust. The investor then may exchange the 1/0 or P/0 securities for the related mortgage-backed security, thus reconstituting the stripped securities.
The investor also might deliver an I/O or P/0 security and cash to a third party who acquires the matching 1/0 and P/0 security and effects the change.
Accounting questions. The accounting questions are:
1. If an 1/0 or P/0 security and cash are exchanged for a mortgage backed security, should the acquired security be recorded at fair value or at amortized cost?
2. If an investor exchanges an I/O or P/0 security from the same trust for the related mortgage-backed security, should the exchange be recorded at fair value or at amortized cost at the exchange date?
The issue. The underlying theoretical issue is whether the exchange involves a culmination of the earnings process. Some believe that in an exchange of an I/0 or a P/0 security for an I/O or P/0 security of a different trust, the acquired security should be accounted for at fair value, unless the exchange involves underlying debt securities that are "substantially the same." They view that exchange as the culmination of the earnings process-the sale of one security and the purchase of a different security.
Others disagree and believe the exchange is only the first step for accomplishing ultimate objective of reconstituting the stripped securities into the underlying debt instruments. Thus, in their view, the exchange does not result in the culmination of the earnings process, and fair value accounting is not appropriate. Until recently, there was no authoritative definition of the term
substantially the same" securities; as a result, diversity in accounting practice developed. In recently issued Statement of Position no. …