[IFRS 9.B4.1.26].
IFRS 9 implies that the underlying pool should consist of financial instruments.
[IFRS 9.B4.1.21(b)]. Contractually linked instruments referencing a pool of non-
financial instruments do not meet the contractual cash flow characteristics test and
cannot be classified at amortised cost. However, a non-recourse financial asset
could pass the contractual cash flow test depending on whether the underlying
assets or cash-flows meet the contractual cash flow criteria. This is the case
whether the underlying assets are financial assets or non-financial assets.
[IFRS 9.B4.1.17]. This highlights a difference in the treatment of contractually linked
and non-recourse instruments. The question therefore arises as to whether the
guidance concerning non-recourse requirements (see 6.5 above) can be applied to
contractually linked instruments.
Some structures contain liquidity facilities which provide short term funding to enable
interest to be paid on notes when cashflows from the underlying assets are delayed, for
instance a facility which provide liquidity to cover the cashflows needed for the SPE to
operate and to pay interest to the noteholders for a short period. These facilities usually
have a seniority above all other notes in the structure and a failure to pay on the facility
would be considered a default of the SPE. Normally these liquidity features would not
be considered to be a tranche of the structure and are seen as being an instrument in
the pool rather than a tranche. This is because they are short term and designed to align
the cash flows in the structure in a similar way to plain vanilla derivative instruments in
(b) above, rather than to absorb risks by the holder and thereby create concentrations
of credit risk.
The standard requires the guidance for contractually linked instruments to apply to all
contractually linked instruments without exception. The scope of contractually linked
instruments is based on the nature of the instruments issued not on the nature of the
pool of assets underlying the instrument. As such it is not possible for a structure which
contains contractually linked instruments to also contain non-recourse assets as well, if
a structure issues multiple contractually linked instruments then the contractually
linked instrument requirements will apply. Furthermore, in a structure where an SPE
Financial
instruments:
Classification
3639
issues contractually linked notes referenced to a non-recourse note issued by another
SPE referencing a pool of non-financial assets, IFRS guidance would require the entity
holding the instrument to look through all contractually linked instruments.
Because of the way the standard is written the outcome of the contractual cash flow
characteristics assessment will depend on the form of the arrangement.
Arrangements which involve using multiple contractually linked instruments should
be assessed under the contractually linked instruments requirements while
arrangements with non-recourse features but without multiple tranches should be
assessed under the non-recourse requirements. Therefore, the accounting outcome
can vary depending on the structure employed, for instance, a non-recourse financial
asset whose cash flows depend on vehicles using a toll road would be required to be
assessed under the non-recourse requirement if structured as a single instrument but,
if structured into tranches, would be assessed differently under the contractually
linked instrument criteria.
In practice it may be difficult for the holder to perform the look-through test because
the underlying reference assets of a collateralised debt obligation (CDO) may not all
have been acquired at the time of investment. In such circumstances, the holder will
need to consider, amongst other things, the intended objectives of the CDO as well as
the manager’s investment mandate before determining whether the investment
qualifies for measurement at amortised cost or fair value through other comprehensive
income. If after this consideration the holder is able to conclude that all the underlying
reference assets of the CDO will always have contractual cash flows that are solely
payments of principal and interest on the principal amount outstanding, the interest in
the CDO can qualify for measurement at amortised cost or fair value through other
comprehensive income. Otherwise, the investment in the CDO must be accounted for
at fair value through profit or loss because it fails the contractual cash flow
characteristics test, unless the effect is de minimis.
If the underlying pool of instruments can change after initial recognition in a way that
does not meet conditions (a) and (b) above, the tranche must be measured at fair value
through profit or loss. However, if the underlying pool includes instruments that are
collateralised by assets that do not meet the conditions above (as will often be the case),
the ability to take possession of such assets is disregarded for the purposes of applying
this paragraph, unless (which will be rare) the entity acquired the tranche with the
intention of controlling the collateral. [IFRS 9.B4.1.26].
The IASB noted that a key principle underlying the contractual cash flow provisions for
contractually linked instruments was that an entity should not be disadvantaged simply
by holding an asset indirectly if the underlying asset has cash flows that are solely
principal and interest, and the holding is not subject to more-than-insignificant leverage
or a concentration of credit risk relative to the underlying assets.
Accordingly, the IASB clarified that a tranche may have contractual cash flows that are
solely payments of principal and interest even if the tranche is prepayable in the event
that the underlying pool of financial instruments is prepaid. The Board noted that
because the underlying pool of assets must have contractual cash flows that are solely
payments of principal and interest, then, by extension, any prepayment features in
3640 Chapter 44
those underlying financial assets are also required to be solely payments of principal
and interest. [IFRS 9.BC4.206(a)].
The Board’s clarification that a prepayment feature in the underlying pool of assets does
not necessarily prevent a tranche from meeting the contractual cash flow characteristics
test is helpful. But, unless the underlying pool can only be acquired at origination, it may
be very difficult to ‘look through’ to the underlying pool to determine if its prepayment
features would themselves be solely payments of principal and interest. This is because
the information will often not be available to determine whether the assets were
acquired at a premium or discount, and whether the fair value of any prepayment
feature was insignificant on acquisition (see 6.4.4 above).
While some contractually linked instruments may pass the contractual cash flow
characteristics test and consequently may be measured at amortised cost or fair value
through other comprehensive income, the contractual cash flows of the individual
tranches are normally based on a pre-defined waterfall structure (i.e. principal and
interest are first paid on the most senior tranche and
then successively paid on more
junior tranches). Accordingly, one could argue that more junior tranches could never
suffer a credit loss because the contractually defined cash flows under the waterfall
structure are always equal to the cash flows that an entity expects to receive, and so
would never be regarded as impaired. This is, because Appendix A of IFRS 9 defines
‘credit loss’ as ‘the difference between all contractual cash flows that are due to an entity
in accordance with the contract and all the cash flows that the entity expects to receive,
discounted at the original effective interest rate’.
However, consistent with treating these assets as having passed the contractual cash
flow characteristics test, we believe that the impairment requirements of IFRS 9 (see
Chapter 47) apply to such tranches if they are measured at amortised cost or fair value
through other comprehensive income. Instead of the cash flows determined under the
waterfall structure, an entity needs to consider deemed principal and interest payments
as contractual cash flows when calculating expected credit losses. In many cases, when
a bank sets up an SPE to securitise assets and issue notes, the bank will also provide a
liquidity facility to the SPE to ensure that interest and principle on the notes can be paid
on time regardless of the timing of the cash flows of the underlying assets. In these cases
the liquidity facility is not considered to be a tranche of the contractually linked
instrument even if it is included in the liquidity waterfall structure of the arrangement
e.g. it is given a place in the subordination ranking of the tranches. The characteristics
of the liquidity facility are sufficiently different from the notes. If the liquidity facility
does not have features that would fail the contractual cash flow characteristics test then
it would be treated as a short term loan.
6.6.1
Assessing the characteristics of the underlying pool
For the purposes of criterion (b) at 6.6 above, the underlying pool may contain financial
instruments such as interest rate swaps. In order for these instruments not to preclude
the use of amortised cost or fair value through other comprehensive income accounting
for holders of a tranche, they must reduce the variability of cash flows, or align the cash
flows of the tranches with the cash flows of the underlying pool of the primary
instruments. Accordingly, an underlying pool that contains government bonds and an
Financial
instruments:
Classification
3641
instrument that swaps government credit risk for (riskier) corporate credit risk would
not have cash flows that represent solely principal and interest on the principal amount
outstanding. [IFRS 9.BC4.35(d)].
If the underlying pool of financial instruments contained a purchased credit default
swap, this would not prejudice the use of amortised cost or fair value through other
comprehensive income accounting provided it paid out only to compensate for the loss
of principal and interest, although in practice it is far more common for underlying pools
to contain written rather than purchased credit default swaps. As a consequence, it may
well be possible to obtain amortised cost or fair value through other comprehensive
income accounting treatment for the more senior investments in ‘cash’ CDOs, i.e. those
where the underlying pool comprises the reference debt instruments. However,
tranches of ‘synthetic’ CDOs for which the risk exposure of the tranches is generated
by derivatives, would not pass the contractual characteristics test.
An underlying pool of financial instruments which contains a financial guarantee issued
by the SPE to provide credit protection to the pool of financial instruments will result
in the instruments supported by the pool failing the SPPI test. This is because the
guarantee does not meet the SPPI test itself and does not reduce cash flow variability
when combined with instruments in the pool nor align cash flows of the tranches with
cash flows of the pool.
An underlying pool containing instruments which have failed derecognition in the
books of the transferee will need to be assessed carefully to understand the cash flows
involved. It should be noted that just because an asset has failed derecognition does not
mean that the transferee is not exposed to any of the risks and rewards of that asset.
Repo balances transferred into the underlying pool will probably not impact the pool’s
ability to pass the SPPI test, given the nature of the cash flows in a repo. However, in
other cases, the transferee could be exposed to some of the risks or rewards associated
with the failed-sale asset. So, depending on the analysis of the instruments involved, it
is possible that the nature of the transferred risks could result in an instrument held
within the pool failing the contractual cash flows characteristic test.
6.6.2
Assessing the exposure to credit risk in the tranche held
IFRS 9 does not prescribe a method for comparing the exposure to credit risk in the
tranche held to that of the underlying pool of financial instruments.
For the more senior and junior tranches, it may become obvious with relatively little
analysis whether the tranche is more or less risky than the underlying assets. In some cases,
it might be possible to compare the credit rating allocated to the tranche as compared with
that for the underlying pool of financial instruments, provided they are all rated.
However, in some circumstances involving complex securitisation structures, a more
detailed assessment may be required. For example, it might be appropriate to prepare
an analysis that involves developing various credit loss scenarios for the underlying pool
of financial instruments, computing the probability weighted outcomes of those
scenarios, determining the probability weighted effect on the tranche held, and
comparing the relative variability of the tranche held with that of the underlying assets,
which is shown in the following example.
3642 Chapter 44
Example 44.32: Assessing the exposure to credit risk in the tranche held
Bank A is the sponsor of a securitisation vehicle (the SPE) and holds the junior notes issued by the SPE. The
SPE’s assets consist of a portfolio of residential mortgages that were originated and transferred to the SPE
by Bank A. The SPE does not hold any derivatives. A number of other banks invest in the mezzanine, senior
and super senior tranches of notes issued by the SPE. None of the banks has any further involvement with
the SPE and all banks have assessed that the SPE is not required to be consolidated in their respective
financial statements. The total notional amount of mortgage assets and notes issued is CU 1,000.
The following table shows a range of expected credit losses for the portfolio of mortgages as at inception and
the estimated probability that those scenarios will occur.
Loss Estimated
Estimated weighted
probability of loss
average loss
CU
%
CU
Scenario I
40
10%
4
Scenario II
70
25%
18
&
nbsp; Scenario III
110
30%
33
Scenario IV
180
25%
45
Scenario V
230
10%
23
Weighted average loss expectancy
123
The probability weighted expected losses of the underlying assets therefore represent 12.3%.
The following table illustrates how an entity may compare the credit risk of the tranche with that of the
underlying pool of financial instruments:
Tranche
Super
senior
Senior Mezzanine
Junior
Total
Notional amount (A)
630
200
90
80
1,000
Probability
Probability weighted expected losses of the tranches*
Scenario I
10%
–
–
–
4
4
Scenario II
25%
–
–
–
18
18
Scenario III
30%
–
–
9
24
33
Scenario IV
25%
–
2
23
20
45
Scenario V
10%
–
6
9
8
23
Expected loss by tranche (B)
–
8
41
74
123
Expected loss % by tranche (B)/(A)
0.0%
4.0%
45.6%
92.5%
12.3%
Credit risk of tranche is less than the
Yes Yes
No No
credit risk of the underlying assets?
Tranche passes the contractual cash
Yes Yes
No No
flow characteristic test
* For each scenario, expected losses are first allocated to the junior tranches and progressively to the more senior tranches until all expected losses are absorbed. For example, in Scenario IV, the loss of CU180 would be absorbed by the Junior
International GAAP® 2019: Generally Accepted Accounting Practice under International Financial Reporting Standards Page 720
