ASU 2010-11 – Scope Exception Related to Embedded Credit Derivatives is an update to FASC 815 – Derivatives and Hedging and is effective for fiscal quarters beginning after June 15, 2010. This ASU clarifies that the scope exception in Paragraphs 815-15-15-8 through 15-9 only applies to the transfer of credit risk in the form of subordination of one financial instrument to another.
This would apply to a securitization that is issued in several tranches and one tranche is subordinate to another tranche of the same securitization. Under these circumstances the embedded credit derivative does not have to be analyzed under the above paragraphs for possible bifurcation.
The ASU gives examples of some transactions that would not be covered under the scope exception:
1. an embedded derivative feature relating to another type of risk,
2. if the holder is exposed to the possibility of being required to make future payments (as opposed to receiving smaller payments), and
3. the securitization only has one tranche.
The second point above, the holder is exposed to the possibility of being required to make future payments was also added as a feature that is not clearly and closely related to the host contract and so would be subject to bifurcation.
Also added to FASC 815 are 4 new examples illustrating the embedded credit derivative scope exception.
The transition provisions for ASU 2010-11 allows for the election of the fair value option for an investment in a beneficial interest in a securitized financial asset upon adoption. Therefore, if the scope exception no longer applies to a financial instrument, the entire financial instrument can be fair valued each reporting period to offset any risk it is intending to hedge.