The Financial Accounting Standards Board is looking at ending a treatment of collateralized debt obligations tranches which keeps losses out of income statements. “Anyone that invests in securitized assets and classifies them as ‘available for sale’ will be affected,” said Eric Smith, an industry fellow with the standard setter in Norwalk, Conn.
Assigning assets as available for sale allows investors to carry them at fair value, and therefore keeps losses off the income statement so long as securities are not sold before maturity. Without the loophole, some players may reconsider investing in securitized assets, according to Smith.
The FASB will meet Jan. 19 to debate whether subordinated CDO tranches will be subject to Financial Accounting Standard No. 133, which requires U.S. companies to value derivatives positions at market values. If FAS 133 guides CDO tranche accounting, Emerging Issues Task Force No. 9920 will not, rendering the income statement benefits it offers unavailable.
At least one of seven board members believes subordinate tranches include embedded derivatives, which fall under FAS 133. The standard would require such tranches be bifurcated, or split into its derivative and non-derivative components, so the derivative can be measured at fair value. In place of bifurcation, practitioners may chose the ‘fair value option,’ which subjects the whole hybrid instrument to fair value measurement.
Smith explained that in the case of bifurcation, the change in value of the derivative would go onto the income statement. With the fair value option, the change in value of the whole instrument would be recorded. “It’s going to result in some or all changes in fair value going onto income statements,” Smith said. That is, if the FASB decides on Jan. 19 to subject subordinated tranches to FAS 133.
“From a theoretical or conceptual basis, [saying subordinated tranches contain embedded derivatives] makes sense,” Smith said. “By me having the lowest tranche, I am really protecting the guys above me,” he explained, noting the similarity such strategies have with purchasing credit default swaps. Yet despite conceptual parallels, he doesn’t think the board will go for this idea because it doesn’t work practically.
Four votes are needed to pass the proposal of changing CDO subordinate tranche accounting which, if approved, could become part of the FAS 133 amendment the board hopes to pass by year-end.
