Derivatives Implementation Group
Statement 133 Implementation Issue No. C13 [Previously No. E13]
| Title: | Scope Exceptions: When a Loan Commitment Is Included in the Scope of Statement 133 |
| Paragraph references: | 9, 57(c)(2), 291 |
| Date cleared by Board: | March 13, 2002 |
| Date posted to website: | April 10, 2002 |
| Date revision posted to website: | May 1, 2003 |
| Affected by: | FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
(Revised March 26, 2003) |
QUESTION
In what circumstances must a loan commitment be included in the scope of Statement 133 and accounted for as a derivative instrument?
BACKGROUND
Loan commitments1are legally binding commitments to extend credit to a counterparty under certain pre-specified terms and conditions. They have fixed expiration dates and may either be fixed-rate or variable-rate. Loan commitments can either be revolving (in which the amount of the overall line of credit is re-established upon repayment of previously drawn amounts) or non-revolving (in which the amount of the overall line of credit is not re-established upon repayment of previously drawn amounts). Loan commitments can be distributed through syndication arrangements, in which one entity acts as a lead and an agent on behalf of other entities that will each extend credit to a single borrower.
Loan commitments generally permit the lender to terminate the arrangement under the terms of covenants negotiated under the agreement. As discussed in EITF Issue No. 87-30, "Sale of a Short-Term Loan Made under a Long-Term Credit Commitment," two types of financial-related covenants are (1) covenants that permit the lender to determine the borrower's compliance subjectively ("subjective covenants"); that is, they contain provisions that can be evaluated differently by the parties to the agreement, such as a provision referring to a material adverse change and (2) covenants that require the financial institution to determine the borrower's compliance objectively ("objective covenants"); that is, they typically refer to financial ratios and other data.
Types of loan commitments include (but are not limited to) the following:
- One- to four-family residential mortgage loan commitments
- Loan commitments for multifamily properties, commercial real estate, construction, and land development
- Commercial loan commitments (that is, commitments to extend credit to commercial or industrial entities)
- Credit card lines (that is, commitments to extend credit to individuals or commercial or industrial entities through credit cards)
- Home equity lines (that is, commitments to extend credit under revolving, open-end lines of credit secured by one- to four-family residential property)
- Manufactured housing
- Automobile financing
- Sub-prime lending.
Statement 133 References
Loan commitments are discussed in paragraphs 291 and 292 of the basis for conclusions of Statement 133. Those paragraphs state:
This Statement's definition of derivative contracts excludes certain contracts that were included in the scope of Statement 119. For example, a loan commitment would be excluded if it (a) requires the holder to deliver a promissory note that would not be readily convertible to cash and (b) cannot readily be settled net. Other conditional and executory contracts that were included in the scope of Statement 119 may not qualify as derivative instruments under the definition in this Statement. The Board decided that some change in scope from Statement 119 is an appropriate consequence of defining derivative instruments based on their primary characteristics. [Emphasis added.]
This Statement supersedes Statement 119. Therefore, one result of excluding instruments that were included in the scope of Statement 119 from the scope of this Statement is that some disclosures previously required for those excluded contracts will no longer be required. The Board considers that result to be acceptable. Moreover, Statement 107 continues to require disclosure of the fair value of all financial instruments by the entities to which it applies.
Based on discussions during the deliberations leading to Statement 133, some believed that loan commitments were not covered by the scope of Statement 133. However, prior to the amendment by Statement 149, paragraph 10 of Statement 133 does not provide an explicit scope exception for loan commitments. Assuming the other characteristics of the definition of a derivative are met, paragraph 291 indicates that if a loan commitment meets one of the criteria for net settlement from the perspective of either the lender or borrower, either because it can readily be settled net by a means outside the contract as discussed in paragraph 9(b) or because the underlying loan is readily convertible to cash as discussed in paragraph 9(c), both parties must consider that loan commitment to meet the definition of a derivative in Statement 133.
Perceived Conflict with Existing GAAP Prior to Amendments by Statement 149
While in some circumstances loan commitments can meet the definition of a derivative instrument in Statement 133, an overlap exists between a requirement to account for loan commitments as derivatives and the existing accounting guidance for loan commitment fees and costs in paragraphs 8–10 of FASB Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, and paragraphs 21–27 of FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities (as amended). The accounting requirements of Statement 91 and Statement 65 (as amended) for loan and commitment fees are as follows:
- Paragraphs 8–10 of Statement 91 address the accounting for loan commitment fees and costs. Paragraph 8 generally requires that fees received for a commitment to originate or purchase loan(s) be deferred and recognized over the life of the loan as an adjustment of the yield if the commitment is exercised. Paragraph 10 states that available lines of credit under credit card and similar charge card arrangements are loan commitments, and requires that fees that are periodically charged to cardholders be deferred and recognized on a straight-line basis over the period the fee entitles the cardholder to use the card.
- Paragraphs 21–27 of Statement 65 (as amended by Statement 91) address the accounting for loan and commitment fees related to mortgage loans that will either be held for resale or held for investment. As indicated in paragraph 21 of Statement 65 (as amended) there is a distinction between the accounting models for fees related to the origination of mortgage loans for resale and the origination of mortgage loans for investment. Statement 65 (as amended) requires that (1) if a mortgage loan is held for resale, loan origination fees and direct loan origination costs shall be deferred until the related loan is sold; (2) fees received for guaranteeing the funding of mortgage loans to borrowers, builders, or developers must be accounted for in accordance with paragraph 8 of Statement 91; and (3) if the commitment fee relates to a mortgage loan that will be held for investment, the fees and costs associated with originating or acquiring or committing to originate or acquire loans for investment be accounted for as prescribed in Statement 91.
Accordingly, Statement 91 and Statement 65 require different income recognition patterns than would be required if a loan commitment was accounted for as a derivative and measured at fair value with changes in fair value recognized currently in earnings under Statement 133. Those paragraphs in Statement 91 and Statement 65 cited above were not amended by Statement 133. Further, paragraph 10 of Statement 133 (as originally issued) did not include an explicit scope exception for loan commitments.
RESPONSE
Loan commitments that relate to the origination of mortgage loans that will be held for resale, as discussed in paragraphs 21 and 23 of Statement 65 (as amended), must be accounted for as derivative instruments in accordance with Statement 133. Those loan commitments are subject to Statement 133 if they are legally binding contracts, regardless of the existence of a material adverse change clause that may be invoked by a lender to terminate the arrangement based either on a subjective evaluation that a material adverse change has occurred or on criteria that are objectively determinable. However, the holder of the commitment (that is, the potential borrower under the arrangement) is not required to account for its contract as a derivative. That exception is limited to loan commitments that relate to the origination of mortgage loans that will be held for resale and no analogy is permitted for other types of contracts.
The accounting for loan commitments discussed in the above paragraph as derivatives by the lender recognizes that a distinct accounting model exists in Statement 65 for mortgage loans originated to be held for resale. In addition, the ability to convert the underlying loan to cash is inherent in the business activity of entering into loan commitments to originate mortgage loans to be held for resale.
However, loan commitments that relate to the origination of mortgage loans that will be held for investment, as discussed in paragraph 25 of Statement 65 (as amended), must continue to be accounted for in accordance with the requirements of that paragraph. That is, paragraph 25 of Statement 65 (as amended) requires that fees and costs associated with originating or committing to originate loans for investment shall be accounted for as prescribed in Statement 91. Further, commitments that relate to the origination of other types of loans (that is, other than mortgage loans) that are not covered by the scope of Statement 65 must also continue to be accounted for in accordance with the guidance in Statement 91. For example, commitments to extend credit to commercial or industrial entities that will not give rise to mortgage loans must be accounted for in accordance with the guidance in Statement 91. In those cases, Statement 133 does not override the existing accounting requirements of Statement 91.
The conclusions herein result in a scope exception to Statement 133 for loan commitments that would otherwise be subject to the scope of that Statement but that relate to the origination of mortgage loans that will be held for investment purposes and all loan commitments that relate to the origination of other types of loans. In addition, the guidance in this Issue results in a scope exception to Statement 133 for the holder of a loan commitment that relates to the origination of mortgage loans that will be held for resale (that is, the potential borrower under such an arrangement).
At the March 13, 2002 meeting, the Board reached the conclusions outlined in this Response section. The guidance in this Issue should not be applied by analogy to other types of contracts.
Statement 149 amended Statement 133 to incorporate those conclusions. Specifically, the following paragraph is added after paragraph 6(c) of Statement 133:
Notwithstanding the above characteristics, loan commitments that relate to the origination of mortgage loans that will be held for sale, as discussed in paragraph 21 of FASB Statement No. 65, Accounting for Mortgage Banking Activities (as amended), shall be accounted for as derivative instruments by the issuer of the loan commitment (that is, the potential lender). (Paragraph 10(i) provides a scope exception for the accounting of loan commitments by issuers of certain commitments to originate loans and all holders of commitments to originate loans (that is, the potential borrowers).
In addition, Statement 149 added a new scope exception in paragraph 10(i), as follows:
Loan commitments. The holder of any commitment to originate a loan (that is, the potential borrower) is not subject to the requirements of this Statement. Issuers of commitments to originate mortgage loans that will be held for investment purposes, as discussed in paragraphs 21 and 25 of Statement 65, are not subject to this Statement. In addition, issuers of loan commitments to originate other types of loans (that is, other than mortgage loans) are not subject to the requirements of this Statement.
The amendments of Statement 133 related to loan commitments and the conclusions outlined in this Issue do not affect the accounting for commitments to purchase or sell mortgage loans or other types of loans at a future date. Those types of loan commitments must be evaluated under the definition of a derivative to determine whether Statement 133 is applicable.
EFFECTIVE DATE AND TRANSITION
The effective date of the implementation guidance in this Issue for each reporting entity is the first day of the first fiscal quarter beginning after April 10, 2002. If an entity had not accounted for a contract as a derivative in its entirety but is required to do so, the entity shall account for the effects of initially complying with the implementation guidance in this Issue prospectively for all existing contracts as of the effective date of this Issue and for all future transactions. In that case, the effects of initially applying this guidance should be reported as a change in accounting principle. If a contract that would not be accounted for as a derivative instrument under this Issue was previously accounted for as a derivative instrument, that accounting treatment shall not be changed. That is, for those contracts, this Issue applies prospectively only to transactions after the effective date. The revisions made on March 26, 2003, relate to the amendments made by Statement 149 and clarification that the scope exception for loan commitments does not apply to contracts for the acquisition of pre-existing loans. Those revisions are effective for contracts entered into or modified after June 30, 2003.
__________________
1The description of loan commitments in this section is not an authoritative or all-encompassing definition. Primary information sources include the instructions for bank Call Reports (FFIEC 031, Consolidated Reports of Condition and Income for a Bank with Domestic and Foreign Offices), June 2001, and The Encyclopedia of Banking and Finance.
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.