New accounting rules for investors in credit-sensitive ABS and MBS.

• Author: Rosenblatt, Marty

EITF 99-20 sets forth the rules (effective in the second quarter of 2001) for (1) recognizing interest income (including amortization of premium or discount) on (a) all credit-sensitive mortgage and asset- backed securities and (b) certain prepayment-sensitive securities including agency IOs and (2) determining when these securities must be written down to fair value because of impairment. Existing GAAP did not provide guidance for securities whose cash flows change as a result of both prepayments and credit losses and, in some cases, interest rate resets.

1. SCOPE

   EITF 99-20 adopts the "prospective method" for adjusting the level yield used to recognize interest income when estimates of future cash flows on the security either increase or decrease since the date of the last evaluation (typically quarterly).

   The impairment provisions of 99-20 bring us much closer to a lower-of-amortized cost or fair value approach than existing GAAP. Effectively, two sets of books are maintained: one at amortized cost and one at fair value. If (1) fair value is less than amortized cost and (2) the present value of the estimated cash flows have decreased since the last estimate was made (other than as a result of an interest rate reset of a plain-vanilla floater), then you must write-down the security to fair value through current earnings.

   Securities covered by 99-20 include:

   * All ABS, CDOs, CMBS and MBS that are not (1) guaranteed by the government, its agencies or guarantors of similar credit quality or (2) sufficiently collateralized to ensure that the possibility of credit loss is remote (minimum rating requirements for exclusion from 99-20 were not specified)

   * All IOs, including agency IOs and any other premium securities where prepayments could cause the holder not to recover substantially all of their recorded investment. (Agency POs are excluded.)

   The above securities are covered by 99-20 regardless of whether they are:

   * Securities purchased by investors or securities retained by securitizers

   * Fixed rate or floating rate securities

   * Publicly-offered or privately-offered securities

   * Securities classified as held-to-maturity or available-for-sale. If classified as trading, they are already being marked to market, but the interest income recognition portion of 99-20 applies if the holder is required to report interest income separately in their income statement pursuant to industry practice.

   * Securities designated as notes, bonds, pass-throughs...