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Collateralized mortgage obligations (CMOs).

ISSUE NO. 89-4

CMOs are created by segregating mortgage collateral (such as Ginnie Maes and mortgage loans) into a pool and selling bonds whose principal and interest will be paid from the colateral payments and reinvestment income.

Regardless of legal form, some CMOs have characteristics of debt instruments. They have stated principal amounts and interested rates.

Other CMOs have equity characteristics. Purchasers of these CMOs are entitled to the issuer's excess cash flows from the mortgage collateral over the amounts required for debt service and administrative expenses.

The task force considered three accounting issues for a purchased investment in a CMO. They are:

1. Which factors should be considered to determine whether to account for CMOs as equity or nonequity? Should they be its legal form, economic substance or other factors?

2. What common attributes of nonequity high-risk CMOs distinguish them as a group of instruments that should be accounted for in a similar manner?

3. How should an investment in a nonequity CMO be accounted for in subsequent periods? How should the cash flows be allocated between income and return on investment?

Consensus. The EITF considered these issues at seven task force meetings during the past year. It also appointed a working group, a rare move for the EITF, to recommend possible solutions. Finally, at the May 31, 1990, meeting, the task force reached the following consensuses:

Issue no. 1. The task force decided the accounting for a purchased investment in a CMO generally should follow its form. However, if all of the following criteria are met, the equity CMO (in form) should be accounted for as a nonequity instrument:

* The issuer's assets didn't come from the CMO purchaser.

* The issuer's assets consist of only high-credit-quality monetary assets for which prepayments are both probable and their timing and amounts are reasonably estimable.

* The issuer is self-liquidating. That means the issuer will terminate when its existing assets and liabilities are collected and paid.

* Assets collateralizing the issuer's obligations may not be exchanged, sold or otherwise managed as a portfolio. Also, the purchaser may not substitute assets that collateralize the issuer's obligations.

* There's no more than a remote chance the purchaser would need to pay for the issuer's administrative or other expenses.

* No other obligee of the issuer has recourse to the buyer of the investment.

Provided these criteria are met, the ability of the purchaser of a CMO to call other CMOs of the issuer generally will not preclude accounting for the investment as nonequity.

CMOs issued in equity form that don't meet these criteria should follow the accounting in Accounting Principles Board Opinion no. 18, The Equity Method of Accounting for Investments in Common Stock, or Accounting Research Bulletin no. 51, Consolidated Financial Statements, as amended by FASB Statement no. 94, Consolidation of all Majority-Owned Subsidiaries.

Issue no 2. The task force decided nonequity CMOs that have the potential for loss of a significant part of the original investment because of changes in (1) interest rates, (2) the prepayment rate or (3) reinvestment earnings are high risk and should be accounted for similarly.

CMOs that don't have the potential for loss of a significant part of the original investment, such as principal-only certificates, would not be considered high-risk CMOs. If these CMOs are bought, any premiums or discounts should be amortized in accordance with FASB Statement no. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.

Issue no 3. For CMOs carried at amortized cost, the task force decided: At the purchase date, calculate an effective yield based on the purchase price and anticipated future cash flows.

In the first accounting period, accrue interest income on the investment balance using the effective yield. Apply cash received to accrued interest. Use any excess cash to reduce the investment balance.

At each reporting date, recalculate the effective yield based on the amortized cost of the investment and the then-current estimate of future cash flows (including estimated future prepayments). For a significant CMOs investment, the rate used should be disclosed.

In subsequent accounting periods, use the recalculated rate to accrue interest income on the investment balance. Continue this procedure until all cash flows from the investment are received.

At the end of each period, the amortized balance should equal the present value of the estimated future cash flows discounted at the newly calculated effective yield. That balance should not exceed the undiscounted estimated future cash flows; that is, the effective yield cannot be negative.

The task force said each CMO should be evaluated separately to determine whether expected future cash flows are adequate to recover the recorded balance. Any writedown would establish a new cost, which then would be used to calculate effective yields in subsequent periods.

Disclosure. If significant, the carrying amount and fair value of CMOs should be disclosed in the annual financial statements. If there's no quoted market price, estimates should be made.

OTHER COMMENTS

Some financial instruments are similar to CMOs in that the purchaser receives interest payments (cash flows) from specified mortgages or mortgage-backed securities. These are called interest-only certificates and are similar to high-risk nonequity CMOs because of their potential for loss due to prepayment risk. The task force decided mortgage-backed interest-only certificates should be accounted for in a manner similar to that used to account for high-risk nonequity CMOs.

The task force noted some CMOs and interest-only certificates are similar economically to excess servicing receivables and other mortgage-related investments. Diversity in practice exists to account for those instruments. The task force decided to authorize the working group to ask the FASB to address this matter in a short-term project that should be separate from the financial instruments project.

This consensus supersedes the conclusions in Issue no. 86-38, Implications of Mortgage Prepayments on Amortization of Servicing Rights, Subissue C, "Unanticipated Prepayments and Interest-Only Certificates," with respect to interest-only certificates.

SEC OBSERVER COMMENTS

The SEC observer said the method of adopting the task force conclusions should be disclosed. If adoption of the consensuses materially affects comparability, the nature and effect of adoption (including a quantification of the effects, if practicable) also should be disclosed in the notes to the financial statements.

The SEC observer expressed concern this consensus might be analogized to similar investments in collateralized borrowing structures when (1) the underlying collateral is of a lesser credit quality than that defined in this consensus or (2) the cash flow from the underlying collateral cannot reasonably be estimated. The SEC staff believes such investments "should be accounted for following a conservative method that adequately reflects the nature of those high-risk structures."

By JOHN GRAVES, CPA, director--technical services, and MOSHE S. LEVITIN, CPA, technical manager, of the American Institute of CPAs technical information division.
COPYRIGHT 1990 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Publication:Journal of Accountancy
Date:Nov 1, 1990
Words:1126
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