Diversity of Practice in Accounting for Derivatives Related to Credit Risk Retention

Abstract

One of the Dodd–Frank Act’s improvements to the asset-backed securitization process is known as the “skin in the game” provision because it requires issuers of some types of asset-backed securities to retain at least 5% of the fair value of the issued interests. The thinking is that an issuer will be less likely to lower its underwriting standards if it must retain some of an ABS’s credit risk. This article explains two ways in which an ABS issuer can satisfy the 5% requirement: the vertical method and the horizontal method. Also, the article raises the possibility of diverse practices in valuing the 5% requirement if the issued interests contain embedded derivatives. This is because there are two ways under U.S. GAAP of valuing financial instruments that contain certain embedded derivatives. The article also suggests that the final rule consider the possibility that ABS issuers could use the cash flow hedge accounting technique to manipulate when changes to bifurcated embedded derivatives affect their income statements.

TOPICS: Asset-backed securities (ABS), derivatives applications, legal/regulatory/public policy, risk management