Securitisation – All In Interest Rate Swap Retained – FAQ | IFRS

Securitisation – all in interest rate swap retained

This is an illustration of how derecognition is applied in practice. The objective is to present the mechanics of applying the IFRS 9 requirements for derecognition of financial assets, starting with an analysis of the transaction using the flowchart [IFRS 9 B3.2.1], and culminating with the initial and subsequent accounting entries for both the transferor and transferee.

Background and assumptions

Bank Q assigns 10-year 10% fixed rate pre-payable mortgages with a notional principal of €10 million to an SPE for €10 million of cash on 1 January 20X1.

The SPE issues 10-year floating-rate (Libor based) notes to investors (with quarterly interest payment dates) in various credit-rated tranches that are repaid as the mortgages themselves are repaid. Q does not purchase any of the notes issued by the SPE. An insurance company purchases the unrated notes, which absorb all the expected credit losses on the mortgages.

Q enters into an ‘all-in’ interest rate swap with the SPE, such that Q will continue to receive all the fixed interest (10%) cash flows on the mortgages and pay a floating rate (Libor +2%) to the SPE so the SPE can pay the interest to the noteholders. The notional amount of the swap is set equal to the principal amount of the mortgages. If a mortgage prepays without penalty, the notional amount of the swap is reduced by an equivalent amount without compensation.

Such pre-payments may arise due to mortality, the mortgagee moving house or mortgagees paying up to 15% of the loan per annum. In all other cases, if a mortgagee wishes to pre-pay and interest rates have fallen, it must pay an early redemption penalty equal to the difference between the principal amount repaid and its fair value based on current market interest rates. On such a prepayment, the notional amount of the swap is reduced by an equivalent amount, but the pre-payment penalty that the mortgagee pays – ie, compensation equal to the fair value of the reduction – is paid to Q. If the mortgagee prepays when rates have risen, there is no rebate, and Q, by way of the swap, retains the benefits of such early pre-payments.

Under the terms of the sale agreement, the SPE cannot sell the mortgages. A third party has been hired by the SPE to service the mortgages for a current market fee.

Q has prepared an analysis that shows that pre-payment risk and credit risk are the only significant risks on these loans. However, pre-payment risk is lower than credit risk, as there are limited circumstances in which a mortgagee can prepay without penalty. Q’s analysis demonstrates that it retains less than a majority of the risks and rewards of the mortgages. There is no market for selling mortgages to which Q has access.

Note that continuing involvement is a unique accounting model for which little guidance is provided in IFRS 9. There may therefore be other acceptable ways to account for the following transaction.

Additional information:

  • Fair value of portfolio of mortgages – €10.5 million
  • Carrying value of portfolio of mortgages – €10 million
  • Fair value of all-in interest rate swap – €0.5 million (an asset from Q’s perspective)
  • 10-year Libor is 7.2% (assume a flat curve), and the credit spread remains at 2%.
  • The servicing fee is expected to adequately compensate the third-party servicer

Analysis using the flowchart [IFRS 9 B3.2.1]

Step 1 Consolidate all subsidiaries

The issue of consolidation is beyond the scope of this publication and depends on facts and circumstances (see our publication SIC-12 and FIN 46R – the substance of control for more guidance). For the purpose of this illustration, it is assumed that the SPE is not consolidated.

Step 2 Determine whether the derecognition model should be applied to part of a financial asset (or a group of similar financial assets) or a financial asset (or a group of similar financial assets) in its entirety.

The financial instruments being transferred have similar characteristics. They are all fixed-rate mortgages that mature at approximately the same time (10 years). They should be assessed as a group of similar financial assets in their entirety.

Step 3 Have the rights to the cash flows expired?

No, the portfolio of mortgages has not yet reached maturity, so the rights to the cash flows still exist.

Step 4 Is there a transfer?

Yes, as bank Q has assigned the mortgages to a non-consolidated SPE, it has transferred the contractual rights to the cash flows from loans to the SPE, a third party, and would have a transfer under IFRS 9 3.2.4 (a).

Helpful hint

Had it been concluded that bank Q does consolidate the SPE, the pass-through tests would need to be assessed as follows:

  • Test (a) failed – Q has an obligation to pay amounts to the eventual recipients (investors in the notes) even if it does not collect equivalent amounts from the mortgages. This is because the all-in interest rate swap may require a net payment to the SPE (that is then passed to noteholders) if interest rates rise so that the interest due on the notes exceeds that due on the mortgages.
  • Test (b) passed – Q is prohibited by the terms of the transfer contract from selling or pledging the mortgages other than as security to the investors for the obligation to pay them cash flows.
  • Test (c) passed – Q does have an obligation to remit any cash flows it collects on behalf of the investors without material delay – ie, quarterly.

Q would fail one of the pass-through requirements and therefore fail derecognition.

Step 5 Risks and rewards analysis Securitisation – all in interest rate swap retained

Bank Q has transferred all of the credit risk on the mortgages to the holders of the notes issued by the SPE. Q retains all the pre-payment risk on the mortgages. Q’s analysis shows that prepayment risk is lower in comparison to credit risk because generally if pre-payment occurs, the mortgagee is required to pay a pre-payment penalty with the effect that Q receives the then current fair value of the loan and therefore suffers no loss from pre-payment. Hence pre-payment risk arises only in cases when a loan may be prepaid without penalty (in which case, Q suffers the pre-payment risk). Such pre-payments may arise due to mortality, mortgagees moving house or mortgagees paying up to 15% of the loan per annum. Therefore, Q has retained some but not substantially all risks and rewards.

Step 6 Control Securitisation – all in interest rate swap retained

The SPE does not have the practical ability to sell the mortgages unilaterally. The terms of the transfer prevent the SPE from selling the mortgages, and hence Q still controls those mortgages. Therefore, Q will continue to recognise the mortgages to the extent of its continuing involvement.


Transferor’s accounting

On the date of the transfer

As Q has neither retained nor transferred substantially all the risks and rewards of ownership of the mortgages and the SPE does not have the practical ability to sell the mortgages, it should continue to recognise the mortgages to the extent of its continuing involvement. The extent of Q’s continuing involvement is the extent to which it is exposed to changes in the value of the mortgages, which in this case arises from the retained pre-payment risk on the mortgages. This will be calculated as the maximum amount of interest receipts on the mortgages to which Q is still exposed – ie, all of the interest receipts on the mortgages at 10%.

The associated liability will be the continuing involvement asset minus the fair value of the all in interest-rate swap. The resulting net position on the balance sheet of the continuing involvement asset and liability will be the fair value of the interest rate swap.

The continuing involvement asset is calculated as follows:

(In € thousands)

The asset is €6,145,000, which is the present value of a 10% interest strip for 10 years (discounted at the original effective interest rate of 10%), assuming no pre-payments. This represents the maximum cash flows the transferor is exposed to.

The liability is the present value of the cash flows arising on the floating leg of the swap.

Accounting entries on date of transfer (1 January 20X1)

(in €)

DR

CR

Cash Securitisation – all in interest rate swap retained

10,000,000

Mortgages Securitisation – all in interest rate swap retained

To record the cash received on sale of the mortgages

10,000,000

Continuing involvement asset Securitisation – all in interest rate swap retained

6,145,000

Continuing involvement liability Securitisation – all in interest rate swap retained

5,853,000

Profit or loss Securitisation – all in interest rate swap retained

292,000

To recognise Q’s continuing involvement asset in the form of the interest strip on the mortgages and its associated liability such that the net is the amortised cost of the rights and obligations retained by the entity.

This results in:

  • The continuing involvement asset being recorded at the previous carrying amount of the interest strip, assuming no pre-payments (ie, 11,000 per annum discounted at the original effective interest rate of 10%).
  • The profit recognised on partial disposal reflecting the difference between the carrying amount of the principal discounted at the original effective interest rate (10,000/(1+10%)10) and the fair value of the principal discounted at the current market rate of interest (10,000/(1+9.2%)10).
  • The continuing involvement liability representing the obligation to pay the floating leg of the swap, discounted at the current market rate of interest (ie, €920 per annum discounted at 9.2%).

Helpful hint

For illustration purposes, we have shown a credit to loans of 10 million and a debit of 6,145,000 for the new continuing involvement asset. In practice, these entries would be combined, as the continuing involvement asset is a retained part of the transferred loans – it is not a new asset. In addition, the entity might have concluded that their maximum exposure was only to an interest rate strip of 8%, as there is +2% on the floating leg of the swap, which would make the gross balance sheet asset and liability different, but the net would still be the same.

In addition, we have determined the continuing involvement asset assuming no expectation of prepayments. As an alternative, the continuing involvement asset could have been determined based on some level of expectation of prepayments. This would have resulted in a smaller gross asset and liability but the net should still be the same.

Subsequent accounting

Subsequently, bank Q will amortise the continuing involvement asset and liability using the effective interest method. To the extent pre-payments occur this will result in impairment of the asset.

Assume Q is preparing its 31 December 20X1 financial statements. Only 0.1% of the mortgages have prepaid during the year in line with expectations. There were no pre-payment penalties associated with these early redemptions. Assume the floating leg (Libor +2%) of the interest-rate swap has risen to 10.5%.

The journal entries would be as follows:

(in €)

DR

CR

Cash Securitisation – all in interest rate swap retained

Coupon of 10% received – on a notional principal of 99.99 million

(910 million less 0.1% pre-payment)

999,000

Interest income Securitisation – all in interest rate swap retained

To accrue interest on the continuing involvement asset at 10%

614,500

Continuing involvement asset Securitisation – all in interest rate swap retained

To record interest income on the asset on an effective interest rate basis

384,500

Cash (pay floating leg of swap at 10.5% on principal of 99.99 million)

1,048,950

Interest expense

To accrue interest on the continuing involvement liability at the original effective interest rate, which for the floating leg is the market rate at the date of transfer – 9.2%

538,476

Continuing involvement liability Securitisation – all in interest rate swap retained

To record interest expenses on the liability on an effective interest rate basis Securitisation – all in interest rate swap retained

510,474

As there are now different cash flow expectations due to the amount that has been prepaid and the change in interest rates, an AG8 cumulative catch-up adjustment should be made to both the continuing involvement asset and liability, with a corresponding adjustment to profit or loss.

Continuing involvement asset

To remeasure the asset to reflect the change in cash flows due to pre-payments of 0.1% (5,753,264 – (6,145,000 – 384,500))

7,236

Continuing involvement liability2

To remeasure the liability to reflect the change in expected cash flows based on the current floating rate of 10.5% (Libor + 2%) under a cumulative catch up method (6,237,904 – (5,853,000 – 510,474)) Securitisation – all in interest rate swap retained

895,378

Profit or loss Securitisation – all in interest rate swap retained

902,614

  1. The continuing involvement asset should represent the gross amount of cash Bank Q might receive under the fixed leg of the swap (for example the fixed cash flows on the remaining mortgages that have not repaid). As some mortgages have pre-paid, the maximum cash flows need to be amended for that. On an amortised cost basis, an adjustment to the carrying amount of the asset of 97,236 as per IAS 39 AG8 is required to remeasure the asset to the new maximum cash outflows of 9999,000 for the next nine years discounted at the original EIR of 10% (ie, 95,753,264) assuming no further changes to pre-payments.

  2. The continuing involvement liability should represent the gross amount of cash Q is required to pay under the floating leg of the swap, discounted at the original effective interest rate (ie, its obligations on an amortised cost basis). As interest rates have increased, more cash will be paid under the floating leg of the swap. On an amortised cost basis, an adjustment to the carrying amount of the liability of 9895,318 is required by IAS 39 AG8 to remeasure the liability to the new estimated cash outflows of 91,048,950 for the next nine years (ignoring pre-payments and assuming a flat yield curve) discounted at the original EIR of 9.2% (ie, 96,237,904).

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