To standardize the process of securities issued by Freddie Mac and Fannie Mae, the Federal Housing Finance Agency (FHFA) created the Single Security Initiative (SSI), which mandates changes to the existing security issuance programs related to securities issued by Fannie Mae and Freddie Mac. This new process will require both entities to issue Uniform Mortgage-Backed Securities (UMBS) instead of their current participation certificates (issued by Freddie Mac) or mortgage-backed securities (issued by Fannie Mae).
The SSI has three relevant features that affect a company’s accounting of the transactions: (1) the conversion of existing securities to the newly issued UMBS, (2) the make-whole payment and (3) the inducement fee.
FHFA offers companies the ability to convert their existing securities into a new UMBS to accelerate implementation and adoption of the SSI.
The underlying terms of the new UMBS are similar to the terms of the current participation certificates and mortgage-backed securities, except for differences in the remittance periods. The Freddie Mac participation certificates have a 45-day remittance period, and the Fannie Mae mortgage-backed securities have a 55-day remittance period. The newly issued UMBS certificates will have 55-day remittance periods, which means holders of participation certificates will experience longer delays in remittance payments under the new UMBS structure.
Because a UMBS provides for a 55-day remittance cycle instead of the 45-day remittance cycle associated with the corresponding participation certificate, the UMBS holder will receive scheduled payments of principal and interest 10 days later than the holder would receive those payments under the participation certificate structure. As a result, Freddie Mac will make a one-time payment to participation certificate holders who choose to participate in the conversion (make-whole payment).
The make-whole payment will be calculated based on the present value of 10 additional days of payment delay over the expected term of the relevant participation certificate. At present market rates, the amount of the make-whole payment is expected to be between five and 15 basis points multiplied by the outstanding principal balance of the participation certificate.
Freddie Mac also may offer a participation certificate holder a payment intended to induce the holder to participate in the conversion (inducement fee). The combined amount of the make-whole payment and any inducement fee will not be more than 25 basis points multiplied by the outstanding principal balance of the participation certificate.
The SSI will be implemented on June 3. However, investors will be allowed to participate in the conversion program prior to implementation.
The changes introduced by the SSI present two primary accounting considerations for companies. Specifically, companies must consider how to account for conversion of securities under this program, as well as how to account for the make whole payments and inducement fees.
The conversion of securities under this program analogize to the accounting guidance for loan refinancing or restructuring, as presented in ASC 310-20-35. Under this guidance, it’s necessary to determine if the modification of cash flows will be considered a modification of a debt instrument that is considered more than minor.
Paragraph 35-9 states, “If the terms of the new loan resulting from a loan refinancing or restructuring other than a troubled debt restructuring are at least as favorable to the lender as the terms for comparable loans to other customers with similar collection risks who are not refinancing or restructuring a loan with the lender, the refinanced loan shall be accounted for as a new loan. This condition would be met if the new loan's effective yield is at least equal to the effective yield for such loans and modifications of the original debt instrument are more than minor. Any unamortized net fees or costs and any prepayment penalties from the original loan shall be recognized in interest income when the new loan is granted.”
However, paragraph 35-10 states that if the refinancing or restructuring does not meet the condition set forth in paragraph 35-9, or if only minor modifications are made to the original loan contract, the unamortized net fees or costs from the original loan and any prepayment penalties shall be carried forward as a part of the net investment in the new loan. In this case, the investment in the new loan shall consist of the remaining net investment in the original loan, any additional amounts loaned, any fees received and direct loan origination costs associated with the refinancing or restructuring.
Determination of “More Than Minor”
The evaluation for determining if a modification is more than minor is addressed in paragraph 35-11, which states that “a modification of a debt instrument shall be considered more than minor under the preceding paragraph if the present value of the cash flows under the terms of the new debt instrument is at least 10 percent different from the present value of the remaining cash flows under the terms of the original instrument. If the difference between the present value of the cash flows under the terms of the new debt instrument and the present value of the remaining cash flows under the terms of the original debt instrument is less than 10 percent, a creditor shall evaluate whether the modification is more than minor based on the specific facts and circumstances (and other relevant considerations) surrounding the modification. The guidance in Topic 470 shall be used to calculate the present value of the cash flows for purposes of applying the 10 percent test.”
We expect these conversions will result in the conclusion that they are not more than minor, since the terms of the original and converted securities are essentially the same as the originally issued securities, and since the present value structure of the make whole payment will not have a significant effect on the remaining cash flows in either situation. In addition, the inducement payment, combined with the make whole payment, is not expected to exceed 0.25 percent, which indicates that the combined payment would not have a “greater than 10 percent” effect on the remaining cash flows. As such, we expect that the modification will not be more than minor in most cases and that unamortized net fees or costs from the original loan and any prepayment penalties shall therefore be carried forward as a part of the net investment in the new loan.
Make-Whole Payments & Inducement Fees
Companies that participate in this conversion program may receive additional upfront make-whole and inducement payments to adjust for the delayed payment terms and to incentivize early participation. The accounting treatment for these fees most closely aligns with the guidance in paragraph 35-34, which states that “when a lender may receive fees for lending transactions unrelated to the origination of loans, the fees shall be recognized over the remaining life of the loan as an adjustment of yield. In each situation, the lender has made some form of concession to the initial or underlying borrower by altering the original terms of the initial underwriting; thus, any fees received shall be recognized as an adjustment of yield over the remaining life of the loan.”
We recommend companies determine the actual amount of the combined make whole payment and the inducement fees paid on the conversion and verify that such fees are less than 25 basis points of the outstanding principal. If the fees are less than the expected 25 basis points, then the conclusion that the conversion is not more than minor can be supported. However, if the fees exceed 25 basis points, then companies should evaluate and document the present value of the remaining cash flows, in accordance with paragraph 35-11, for the original and converted securities to determine if the conversion is more than minor.
Companies should give additional consideration to securities classified as held-to-maturity if it is determined the conversion is more than minor. If the modification is deemed more than minor, then the transaction is recognized as a sale of the existing security and a purchase of the new security. This could potentially call into question the company’s ability and intent to hold similar securities to term. In certain circumstances, this also could taint the remaining held-to-maturity portfolio and trigger other securities to be reclassified as available for sale.
Further, companies subject to internal control over financial reporting (ICFR) and certification of disclosure requirements under Section 404 of the Sarbanes-Oxley Act of 2002 also should consider their ICFR environment and determine if they have controls to identify and account for unusual transactions and whether these controls operate effectively.
By concluding that the exchange is a minor modification, security holders will adjust the amortized cost basis of the security by the cash received and recognize the cash payment received as a yield adjustment through accretion/amortization of the difference between the amortized cost and face amount over the remaining life of the UMBS received in the exchange. For more information, reach out to your BKD trusted advisor or use the Contact Us form below.