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4.4.5 Beneficial interests in securitizations
Publication date: 30 Nov 2020
us Derivatives & hedging guide
Many securitization transactions involve the transfer of financial assets to a limited-purpose entity through one or more steps. The securitization entity issues various interests in security form (hence the term “securitization”) to third parties that entitle the holders to the cash flows generated by the entity’s underlying financial assets. These interests are commonly referred to as “beneficial interests” in those assets. ASC 860, Transfers and Servicing, defines beneficial interests.
Definition from ASC 860-10-20
Beneficial Interests: Rights to receive all or portions of specified cash inflows received by a trust or other entity, including, but not limited to, all of the following:
- Senior and subordinated shares of interest, principal, or other cash inflows to be passed-through or paid-through
- Premiums due to guarantors
- Commercial paper obligations
- Residual interests, whether in the form of debt or equity
Beneficial interests can take many different forms, ranging from debt securities to equity interests issued by a limited partnership or limited liability company. Examples of beneficial interests in securitizations include mortgage-backed securities, asset-backed securities, credit-linked notes, collateralized debt obligations, and interest-only (IO) or principal-only (PO) strips. The primary investors in beneficial interests in securitizations are insurance companies, banks, broker-dealers, hedge funds, pension funds, and other individuals or companies that maintain a significant investment or trading portfolio. Corporate treasury groups may also invest in beneficial interests. For example, many corporations invest in mortgage-backed securities issued by government-sponsored enterprises, such as Freddie Mac or Fannie Mae. The entity selling assets in a securitization transaction often retains interests in the assets sold. Commonly referred to as retained interests, these are also regarded as forms of beneficial interests.
4.4.5.1 Accounting for derivatives embedded in beneficial interests
Beneficial interests should be evaluated to determine whether they meet the definition of a derivative in ASC 815. See DH 2 for information on the definition of a derivative. If the beneficial interest is an IO or PO strip it may qualify for a scope exception; see DH 3.2.12 for information on the scope exception for certain IOs and POs.
Certain beneficial interests in securitizations (that are not derivatives within the scope of ASC 815) are accounted for like debt securities under ASC 320, as detailed in ASC 860-20-35-2. See LI 3.2.2.1 for information on these instruments.
If a beneficial interest meets the definition of a derivative in its entirety and does not qualify for a scope exception, it must be accounted for as a derivative under ASC 815. It should be initially recorded at its fair value and subsequently measured at fair value each reporting period with changes in fair value recognized in earnings.
Beneficial interests that are not derivatives in their entirety should be evaluated to determine whether they contain embedded derivatives that should be accounted for separately. As discussed in ASC 815-15-25-12, that determination should be based on an analysis of the contractual and implied terms of the beneficial interest, which requires an understanding of the nature and amount of assets, liabilities, and other financial instruments that comprise the entire securitization transaction. It also requires that the reporting entity obtain information about the payoff structure and the payment priority of the instrument.
The evaluation of the clearly and closely related criterion in ASC 815-15-25-1(a) can be more complicated for beneficial interests because the contractual terms might not explicitly acknowledge the presence of embedded derivatives. Therefore, a more holistic analysis of whether the securitization vehicle has entered into contracts that introduce new risks not inherent in the asset portfolio or how the terms of the beneficial interest relate to the assets and liabilities of the securitization vehicle will be required. ASC 815-15-55-222 through ASC 815-15-55-226A provide examples of how to apply the clearly and closely related criterion to beneficial interests in securitized assets. The evaluation of embedded credit derivative features differs from other risks, as discussed in DH 4.4.5.3.
Following is a list of frequently identified potential embedded derivatives found in beneficial interests that require additional analysis. Interest rate and prepayment features are the most common types of embedded derivatives in investments in securitized financial assets.
- Embedded prepayment options in the underlying securitized financial assets
- Embedded put and call options permitting the investor, transferor, or servicer to redeem the beneficial interests
- Servicer clean-up calls
- Options that allow the servicer to purchase loans from the securitization trust (e.g., removal of account provisions)
- Certain explicit derivatives that the securitization vehicle enters into, such as written credit default swaps embedded in synthetic collateralized debt obligation structures
In addition, there may be implicit embedded derivatives when the following exist in the beneficial interests:
- Basis risk from the interest payments of the assets of a securitization entity being based on interest rates (e.g., adjustable rate mortgage based on Treasury rates) that are different from the interest rate underlying the beneficial interests issued (e.g., LIBOR plus a fixed spread)
- Notional mismatches creating basis risk between the balances of assets and liabilities of the securitization vehicle and derivatives the securitization vehicle has entered into may occur as the underlying assets (e.g., mortgage loans) are prepaid
- Differences in the foreign exchange rates associated with the underlying collateral assets and beneficial interests issued
If there is any potential shortfall of cash flows that will be generated by the assets and derivatives held by a trust funding the payment of the beneficial interests (excluding certain credit losses), no matter how remote, the beneficial interest would contain an embedded component that should be evaluated to determine whether it is a derivative that should be separated. A shortfall may occur if the contractual cash flows from the financial instruments in the vehicle (excluding certain credit losses) could be insufficient to fund the payments to the beneficial interest holders. Provided the only underlying risk is interest rate risk, these embedded components should be analyzed under ASC 815-15-25-26(a) to determine whether the cash flow shortfall could result in the investor not recovering substantially all of its initial recorded investment. Similarly, beneficial interests with positive leverage resulting from incremental trust cash flows (i.e., doubling of the initial and the then-market rates of return) should be analyzed under the guidance in ASC 815-15-25-26(b). See FG 1.6.1.2 for information on the embedded interest rate derivative guidance in ASC 815-15-25-26.
The analysis required by ASC 815-15-25-26 is based on the recorded basis of the instrument. When investors purchase prepayable beneficial interests at a substantial premium, it becomes more likely that the securities contain an embedded derivative that should be accounted for separately because the hybrid financial instrument is more likely to be contractually settleable in a way that the investor would not recover substantially all of its initial recorded investment.
Question DH 4-11
A mortgage-backed security (MBS) issuer has the option to call the securities once the number of underlying loans falls below 200. Is the option an embedded derivative that should be accounted for separately?
A mortgage-backed security (MBS) issuer has the option to call the securities once the number of underlying loans falls below 200. Is the option an embedded derivative that should be accounted for separately?
PwC response
Probably not. ASC 815-15-25-37 through 15-39 states that an option that only provides the issuer the right to accelerate the settlement of the debt does not require an assessment under ASC 815-15-25-26(b). Additionally, the option would not be considered an option that is only contingently exercisable under ASC 815-15-25-41 as the number of loans underlying the MBS will eventually reduce to below 200 over the term of the security. As a result, this option would not need to be bifurcated under the embedded derivative guidance in ASC 815-15 unless the instrument was purchased at a significant premium to the redemption price. In that case, it becomes more likely that the securities contain an embedded derivative that should be accounted for separately based on the guidance in ASC 815-15-25-26(a) because the hybrid financial instrument is contractually settleable in a way that the investor would not recover substantially all of its initial recorded investment.
Question DH 4-12
A special purpose entity holding $100 fixed-rate non-prepayable loans issues a $60 Class A beneficial interest that pays floating-rate interest based on LIBOR (with limited exposure to credit losses on the fixed-rate loans) and a $40 Class B residual interest. Do the beneficial interests contain embedded derivatives that should be accounted for separately?
A special purpose entity holding $100 fixed-rate non-prepayable loans issues a $60 Class A beneficial interest that pays floating-rate interest based on LIBOR (with limited exposure to credit losses on the fixed-rate loans) and a $40 Class B residual interest. Do the beneficial interests contain embedded derivatives that should be accounted for separately?
PwC response
The Class A beneficial interest can be viewed as a floating-rate security with an interest rate cap (the return of this Class A beneficial interest is capped by the fixed rate on the prepayable loans). Since the floating rate is capped, it is not likely that the Class A beneficial interest contains an embedded derivative under the guidance in ASC 815-15-25-26.
The Class B beneficial interest has an embedded interest rate swap in which it receives a fixed rate and pays a floating rate on the liabilities issued by the SPE (i.e., floating rate beneficial interests). This embedded interest rate swap should likely be separated from the host beneficial interest based on the guidance in ASC 815-15-25-26. If the floating rate rises, it is possible that the cash flows generated by the loans will not support the terms of the Class A beneficial interests. In that case, the Class B investors would not recover all of their principal. In addition, there are interest rate scenarios that could result in investors doubling both their initial rate of return and the market rate of return for the host beneficial interest.
Question DH 4-13
An investor purchases an agency asset-backed security with a par amount of $100 for $115. The mortgage loans underlying the security are prepayable at par ($100). Does the security contain an embedded derivative that should be accounted for separately?
An investor purchases an agency asset-backed security with a par amount of $100 for $115. The mortgage loans underlying the security are prepayable at par ($100). Does the security contain an embedded derivative that should be accounted for separately?
PwC response
Yes. If the borrowers in the mortgage loans owned by the securitization entity elect to prepay their mortgages (at par of $100) the day after the investor purchases the asset-backed security, the investor would receive approximately 87% of its initial recorded investment of $115. In that case, an embedded interest rate derivative should be separated based on the guidance in ASC 815-15-25-26(a) because the investor would not receive substantially all of its initially recorded investment. The likelihood that the borrowers will elect to prepay the mortgage loans on the next day is irrelevant to the analysis.
Question DH 4-14
An investor pays $115 for a securitized interest with a remaining term of four years, par value of $100 and an interest rate of 7% at a time when market rates for instruments of this credit type are 2%. The assets underlying the securitized interest are not prepayable. The security is not prepayable and does not have any features that could change the timing and amount of cash flows. Does the security contain an embedded derivative that should be accounted for separately?
An investor pays $115 for a securitized interest with a remaining term of four years, par value of $100 and an interest rate of 7% at a time when market rates for instruments of this credit type are 2%. The assets underlying the securitized interest are not prepayable. The security is not prepayable and does not have any features that could change the timing and amount of cash flows. Does the security contain an embedded derivative that should be accounted for separately?
PwC response
No. Since the assets are not prepayable, the investor is guaranteed (absent a default, which should not be taken into account when performing the analysis in ASC 815-15-25-26(a)) to receive its recorded investment of $115 (through the interest and principal payments) by the maturity of the securitized interest. The only potential change in the amount of contractual cash flows to be collected is due to credit. Credit risk is clearly and closely related to a debt host contract and therefore does not create an embedded derivative that needs to be accounted for separately.
4.4.5.2 Beneficial interests in prepayable securitized assets
ASC 815-15-25-33 exempts certain beneficial interests from the ASC 815-15-25-26(b) leverage tests (the double-double test). This exception only applies to embedded derivatives that are tied to the prepayment risk of the underlying prepayable financial assets.
A securitized interest in prepayable financial assets would not be subject to the conditions in paragraph 815-15-25-26(b) if it meets both of the following criteria:
- The right to accelerate the settlement of the securitized interest cannot be controlled by the investor.
- The securitized interest itself does not contain an embedded derivative (including an interest-rate-related derivative instrument) for which bifurcation would be required other than an embedded derivative that results solely from the embedded call options in the underlying financial assets.
The application of the guidance in ASC 815-15-25-33 depends on when the beneficial interest was issued or acquired. If it was issued or acquired after June 30, 2007 (date specified in DIG Issue B40), then the guidance should be applied regardless of the value the other embedded derivative (other than the prepayment option) is expected to have over its life.
If the beneficial interest was acquired before January 1, 2007, the beneficial interest would be grandfathered from being assessed under ASC 815-15-25-26(b). If the beneficial interest was issued after January 1, 2007 but before June 30, 2007, then the criterion in ASC 815-15-25-33(b) would not be applicable if the other embedded derivative will have a greater than trivial fair value only under extremely remote scenarios (e.g., embedded derivative only has value when an interest rate index reaches a remote level).
4.4.5.3 Embedded credit derivatives
Reporting entities are required to evaluate credit derivative features embedded in beneficial interests in securitized financial assets to determine whether they should be separately accounted for. ASC 815-15-15-9 provides a limited scope exception for embedded credit derivative features created by the transfer of credit risk between tranches as a result of subordination.
The transfer of credit risk that is only in the form of subordination of one financial instrument to another (such as the subordination of one beneficial interest to another tranche of a securitization, thereby redistributing credit risk) is an embedded derivative feature that shall not be subject to the application of paragraph 815-10-15-11 and Section 815-15-25. Only the embedded credit derivative feature created by subordination between the financial instruments is not subject to the application of paragraph 815-10-15-11 and Section 815-15-25. However, other embedded credit derivative features (for example, those related to credit default swaps on a referenced credit) would be subject to the application of paragraph 815-10-15-11 and Section 815-15-25 even if their effects are allocated to interests in tranches of securitized financial instruments in accordance with those subordination provisions. Consequently, the following circumstances (among others) would not qualify for the scope exception and are subject to the application of paragraph 815-10-15-11 and Section 815-15-25 for potential bifurcation:
- An embedded derivative feature relating to another type of risk (including another type of credit risk) is present in the securitized financial instruments.
- The holder of an interest in a tranche of that securitized financial instrument is exposed to the possibility (however remote) of being required to make potential future payments (not merely receive reduced cash inflows) because the possibility of those future payments is not created by subordination. (Note, however, that the securitized financial instrument may involve other tranches that are not exposed to potential future payments and, thus, those other tranches might qualify for the scope exception.)
- The holder owns an interest in a single-tranche securitization vehicle; therefore, the subordination of one tranche to another is not relevant.
Reporting entities should still evaluate other derivatives embedded in beneficial interests to determine whether they should be separated, including instances when the beneficial interest has an embedded derivative feature relating to another type of risk (e.g., interest rate risk), including another type of credit risk. The embedded derivative analysis should be based on both the contractual terms of the interest in securitized financial assets and the activities of the securitizing entity. This analysis requires an understanding of the nature and amount of assets, liabilities, and other financial instruments that compose the securitization, as well as the payoff structure and priorities, as discussed in ASC 815-15-25-12 and ASC 815-15-25-13.
However, as it relates to credit risk, a reporting entity should first look into the securitization vehicle to identify whether there are any credit derivatives. If a new credit risk is added to a beneficial interest by a written credit derivative in the securitization structure (e.g., as is the case with a synthetic collateralized debt obligation), the related embedded credit derivative feature is not clearly and closely related to the host contract. We believe the requirement to look into the securitization vehicle applies beyond credit risk; it also applies to any derivative that introduces additional risk to the securitization rather than managing a risk that already exists in the securitization structure.
We believe securitization vehicles that do not contain any derivatives are not affected by this guidance, as illustrated by Case Y in ASC 815-15-55-226, in which the special-purpose entity holds a portfolio of loans that commingle different credit risks. However, there may be embedded derivatives related to non-credit risks that may have to be separated under other provisions in ASC 815.
Question DH 4-15
In a cash collateralized debt obligation (CDO), a securitization entity issues interests to third parties. The repayment of the principal on the notes is based on the performance of debt securities held by the securitization entity. Does the security contain an embedded credit derivative that should be accounted for separately?
In a cash collateralized debt obligation (CDO), a securitization entity issues interests to third parties. The repayment of the principal on the notes is based on the performance of debt securities held by the securitization entity. Does the security contain an embedded credit derivative that should be accounted for separately?
PwC response
Maybe. Since ASC 815-15-15-9 states that credit concentrations in subordinated interests should not be recognized as embedded derivatives, many cash CDOs will not contain an embedded credit derivative because the principal repayment is directly linked to the loans held by the securitization entity (i.e., repayment is based on the credit risk of the loans held by the securitization entity). Reporting entities should analyze the specific facts and circumstances of their arrangements to determine whether there is an embedded credit derivative that requires separate accounting. In addition, an assessment of other embedded derivatives, such as interest and prepayment risk, should be performed.
Question DH 4-16
In a synthetic CDO, a securitization entity issues interests to third parties. The securitization entity holds highly-rated financial instruments (e.g., US Treasury securities) and writes a credit default swap (CDS) to a third party. The repayment of principal and interest on the notes is based on the performance of the CDS (and the underlying collateral). Does the security contain an embedded credit derivative that should be accounted for separately?
In a synthetic CDO, a securitization entity issues interests to third parties. The securitization entity holds highly-rated financial instruments (e.g., US Treasury securities) and writes a credit default swap (CDS) to a third party. The repayment of principal and interest on the notes is based on the performance of the CDS (and the underlying collateral). Does the security contain an embedded credit derivative that should be accounted for separately?
PwC response
Yes. A credit derivative written by a securitization entity would not be considered clearly and closely related to its host beneficial instrument; therefore, it should be separated by the holder. In addition, an assessment of other derivatives, such as interest and prepayment risk, should be performed.
Question DH 4-17
A securitization entity holds $100 of highly-rated collateral and writes a CDS with a notional amount of $20 on referenced credits, and issues notes with a notional amount of $100. Do the securities issued contain an embedded credit derivative that should be accounted for separately?
A securitization entity holds $100 of highly-rated collateral and writes a CDS with a notional amount of $20 on referenced credits, and issues notes with a notional amount of $100. Do the securities issued contain an embedded credit derivative that should be accounted for separately?
PwC response
Yes. The extent of synthetic credit is not relevant to the analysis of embedded credit derivatives. See Case AA in ASC 815-15-55-226C and Case AB in ASC 815-15-55-226D for similar examples.
Question DH 4-18
A credit-linked note (CLN) is created through a synthetic securitization transaction (the securitization entity holds highly-rated financial instruments, writes a credit default swap, and issues notes to third parties.) A guarantor provides a financial guarantee contract guaranteeing the payment of principal and interest of the CLN. If there is a credit event, the financial guarantor will step in and make payments to the note holders. Is that financial guarantee contract eligible for the scope exception under ASC 815-10-15-58?
A credit-linked note (CLN) is created through a synthetic securitization transaction (the securitization entity holds highly-rated financial instruments, writes a credit default swap, and issues notes to third parties.) A guarantor provides a financial guarantee contract guaranteeing the payment of principal and interest of the CLN. If there is a credit event, the financial guarantor will step in and make payments to the note holders. Is that financial guarantee contract eligible for the scope exception under ASC 815-10-15-58?
PwC response
No. A CLN issued as part of a synthetic securitization contains an embedded derivative requiring separate accounting. Since the financial guarantee contract provides coverage on a derivative instrument, it would not be eligible for the exception in ASC 815-10-15-58.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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