FASB Re-Opens for Comment Guidance on Embedded Credit Derivatives Exception


On October 13, 2009, the Financial Accounting Standards Board (“FASB”) re-opened for comment a proposed Accounting Standards Update, Scope Exception Related to Embedded Credit Derivatives (the “Update”),[1] which is intended to clarify when companies using financial instruments with embedded credit derivatives features do not have to apply derivatives accounting rules that require separate accounting of the credit derivative from the contract in which it is embedded.

FASB has noted that an overly broad application of an accounting exception regarding embedded credit derivatives had emerged as an issue during the financial crisis, particularly in connection with collateralized debt obligations, including synthetic collateralized debt obligations.  The FASB board members believed that investors and other users of financial statements had been denied relevant information about certain credit derivatives that were “embedded” in other instruments as a result of over-reliance on this exception.  The Update effectively would tighten the use of this accounting exception, clarifying the scope of exception for credit derivatives and addressing how to determine which such derivatives should be analyzed for potential bifurcation (i.e., being split off from their “host” contracts).  Bifurcation would lead to the relevant credit derivative being accounted for separately.

In particular, the Update clarifies that 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 tranche to another in a securitization, hence redistributing credit risk) constitutes an embedded derivative feature between tranche holders that is not intended to be bifurcated.  In contrast, the holder of an interest in a tranche of securitized financial instruments that is exposed to some possibility of making a payment (i.e., in addition to its initial investment) in the future is subject to bifurcation analysis, as the related transfer of credit risk for that tranche is not only in the form of subordination.  Similarly, the Update clarifies that the embedded derivative scope exception is not available to an interest in a single-tranche securitization vehicle as, of course, no subordination exists in such a structure.

The Update calls for comments on the draft guidance to be submitted by November 12, 2009 and would be effective on the first day of the first quarter beginning after December 15, 2009.

[1] The Update had originally been opened for comment on January 14, 2009 as Statement 133 Implementation Issue No. C22, Scope Exceptions: Exceptions Related to Embedded Credit Derivatives.