Derivatives Implementation Group

Statement 133 Implementation Issue No. F8

QUESTION

In a fair value hedge of a portion of a recognized servicing right asset subsequently measured using the amortization method, may a company designate the hedged item at the inception of the hedge by initially specifying a series of possible percentages of the servicing right asset (that is, preset hedge coverage ratios) that each correspond to a specified independent variable? Under that approach, at the end of the hedge assessment period, the company would determine the hedged item and measure hedge ineffectiveness by determining retrospectively which hedge coverage ratio would be applied to the servicing right asset to identify the hedged item for that period. (That approach is in contrast to designating the hedged item at the inception of the hedge by specifying a single percentage of that recognized servicing right asset as the hedged item.)

BACKGROUND

Paragraph 21(a)(2) of Statement 133 states, in part, "If the hedged item is a specific portion of an asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities), the hedged item is one of the following: (a) A percentage of the entire asset or liability (or of the entire portfolio)...(emphasis added). Paragraph 21(a) begins by stating: "The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability.... Paragraph 20(b) states, in part, that "An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months."

Servicing rights are contracts to service loans, receivables, or other financial assets under which the servicer is obligated to perform specific administration functions and is compensated with contractually specified servicing fees. Servicing rights are separately recognized as either servicing assets or servicing liabilities when an entity undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations as stated in paragraph 13 of FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (as amended by Statement 156):

1. A transfer of the servicer’s financial assets that meets the requirements for sale accounting
2. A transfer of the servicer’s financial assets to a qualifying SPE [special-purpose entity] in a guaranteed mortgage securitization in which the transferor retains all of the resulting securities and classifies them as either available-for-sale securities or trading securities in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities
3. An acquisition or assumption of a servicing obligation that does not relate to financial assets of the servicer or its consolidated affiliates.

   An entity that transfers its financial assets to a qualifying SPE in a guaranteed mortgage securitization in which the transferor retains all of the resulting securities and classifies them as debt securities held-to-maturity in accordance with Statement 115 may either separately recognize its servicing assets or servicing liabilities or report those servicing assets or servicing liabilities together with the asset being serviced.

Statement 140, as amended by Statement 156, requires that if an entity subsequently measures servicing assets and servicing liabilities using the amortization method, any impairment of servicing assets, which is the amount by which the carrying amount of the servicing assets for an individual stratum exceeds their fair value, must be recognized in current earnings. However, an increase in the fair value over the carrying amount of servicing assets for an individual stratum may not be recognized in current earnings.

Companies that service certain types of financial assets may wish to designate as the hedged item in a fair value hedge a pre-specified percentage of the total change in fair value of those servicing rights (attributable to the hedged risk) that varies based on changes in a specified independent variable. (Because the pre-specified percentage for each specified independent variable can be presented in a rectangular array, that method of determining the hedged item retroactively based on the actual independent variable is sometimes referred to as the matrix method.) For example, mortgage banking companies may wish to use that methodology in designating hedges of mortgage servicing right assets (MSRs) for the following reasons:

• If servicing assets are subsequently measured using the amortization method and its related impairment analysis, companies are not able to achieve substantial offset in earnings of gains and losses of those servicing assets and a forward contract when economically hedging those assets with forward contracts unless special hedge accounting could be applied. Absent the application of special hedge accounting, a decrease in the fair value of the MSR below its carrying amount will be recognized in current earnings as an impairment charge and the increase in the fair value of a derivative functioning as an economic hedge is available to offset some or all of that impairment charge. However, in accordance with Statement 140, an increase in the fair value of the MSR above its carrying amount is not recorded in earnings, while the corresponding decrease in the fair value of the derivative would be recognized in current earnings.
• The fair values of MSRs do not change in a linear fashion as interest rates increase or decrease. MSR fair values are most significantly impacted by changes in interest rates and the corresponding effect of those changes on prepayment speed estimates and other interest-rate-based assumptions. Decreases in interest rates generally increase prepayment speed estimates on the underlying loans, which reduces the expected cash flows to be received over the life of the MSR and in turn reduces the MSR's fair value. (Increases in interest rates have the opposite effect.) However, when interest rates fall, prepayment speeds increase at a faster pace than they decrease when interest rates rise. When interest rates decrease, prepayment speeds accelerate until they reach a certain threshold, beyond which they accelerate at a slower pace. Therefore, the effect of changes in interest rates on the fair value of MSRs could be significantly different depending upon the extent of the movement in interest rates because of the asymmetrical rate of prepayment and because they lose value at a faster pace when rates fall than they gain when rates rise (that is, they exhibit negative convexity). As a result, if required to establish a single hedge coverage ratio over a time horizon of any length, companies may be unable to establish at the inception of the hedging relationship that the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk, and, as such, the hedging relationship may not be able to qualify for fair value hedge accounting under Statement 133.
• Because there are no individual derivative products that exactly offset the risk profile of the MSR, mortgage banks generally use combinations of derivatives to hedge MSRs. The negative convexity of MSRs necessitates that the combination of derivatives must have an option-like profile; however, companies typically do not seek to fully replicate the inverse of the MSR risk profile with a combination of derivatives because it is not cost effective.

RESPONSE

No. In a fair value hedge of a portion of a recognized servicing right asset subsequently measured using the amortization method and its related impairment analysis, a company may not designate the hedged item at the inception of the hedge by initially specifying a series of possible percentages of the servicing right asset and then determining at the end of the assessment period what specific percentage of the servicing right asset is the actual hedged item for that period based on the change in a specified independent variable during that period. Thus, the matrix method would not be a valid application of the provisions of Statement 133. The reference in paragraph 21(a)(2)(a) of Statement 133 to “a percentage of the entire asset or liability (or of the entire portfolio)” means that only a single percentage (that is, “a specific portion”) can be designated at the inception of the hedge as the hedged item. Paragraph 21(a)(2)(a) does not permit expressing the hedged item as multiple percentages of a recognized asset or liability and then retroactively determining the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed. (However, refer to the limited exception under Statement 133 Implementation Issue No. E18, “Designating a Zero-Cost Collar with Different Notional Amounts as a Hedging Instrument,” in which a collar that is comprised of one purchased option and one written option that have different notional amounts is designated as the hedging instrument, and the hedged item is specified as two different proportions of the same asset based on the upper and lower rate or price range of the asset referenced in those two options.)

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.