Accounting for Mortgage-Backed Securities

What are Mortgage-Backed Securities?

Mortgage-backed securities (MBS) are financial instruments that have similar characteristics as bonds. These securities use mortgages or a collection of mortgages as collateral. Like other financial instruments, MBS also gets traded in the market. Mortgage-backed securities are a type of asset-backed securities and allow investors to deal in mortgages. Through these, investors can invest in mortgages, which is usually not possible otherwise.

Through mortgage-backed securities, investors get the right to receive the value of a group of mortgages. However, they also undertake the risks associated with those mortgages. MBSs also provide financial institutions with an advantage to raise more capital to invest in mortgages. Financial institutions providing these securities bundle various mortgages together through the process of securitization.

Securitization serves as a base for mortgage-backed securities or asset-backed securities. This process allows issuers to market their illiquid assets or securities to investors. It also provides them with the opportunity to raise more capital and alleviate their credit risk. The accounting for mortgage-backed securities is similar to financial instruments based on securitization.

What is the accounting for Mortgage-Backed Securities?

When accounting for mortgage-backed securities, buyers treat it like any other financial instrument. The accounting treatment for mortgage-backed securities differs between IFRS and GAAP.

IFRS accounting treatment for Mortgage-Backed Securities

When a reporting entity acquires MBS, it must treat it as an investment. Under IFRS, buyers must ensure the securities meet two tests. The business model test relates to the objective of holding these securities. The cash flows’ characteristics test looks at whether the cash flows from the security include payments of interest and principal amounts.

Mortgage-backed securities meet both of these tests. IFRS 9 requires reporting entities to treat these securities under the amortized cost model. Initially, reporting entities must recognize these securities at fair value plus transaction cost. Therefore, the accounting entries for the initial recognition will be as follows.

Dr Mortgage-backed securities

Cr Cash/Bank

Subsequently, reporting entities must account for these securities under amortized cost. This method will include recording any interest and principal payments received from the instruments. Any interest received from mortgage-backed securities will be considered income for the reporting entity. The accounting treatment for interest from these securities will be as follows.

Dr Bank/Cash

Cr Interest Income

Any principal repayments will be similar. However, they will not be an income but rather a reduction in the value of the mortgage-backed security on the balance sheet. If these securities do not match the tests outlined by IFRS, reporting entities must treat them under the fair value model.

GAAP accounting treatment for Mortgage-Backed Securities

Under GAAP, reporting entities must report mortgage-backed securities at the current value rather than historical cost. However, establishing a fair value for MBS is challenging due to the absence of observable inputs. Therefore, mortgage-backed securities fall into the Level 3 categorization of assets established by FASB 157.

Level 3 assets are the least marked to market of the categories. Therefore, reporting entities must base their measurements on models and unobservable inputs. This process can increase the volatility of the current value between two reporting periods. Therefore, GAAP requires reporting entities to reconcile the opening and closing balances for level 3 assets. On top of that, there is a more stringent disclosure requirement for these assets.

Conclusion

Mortgage-backed securities are securities that include a mortgage or a collection of mortgages as collateral. These securities are a variation of asset-backed securities. They use securitization as a basis. The accounting for mortgage-backed securities under IFRS requires entities to record it at amortized cost. However, it may also allow for fair value measurement. Under GAAP, these securities are a level 3 asset and are recognized at fair value.

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