Accounting for Credit Enhancements in Loan Structures
When lending arrangements get complicated, financial institutions must determine whether enhancements are in the loan agreement or in freestanding contracts.
As financial institutions increasingly collaborate with fintech partners and third parties to strategically originate or purchase loans, contractual arrangements might diverge from traditional loan structures. Credit enhancements – now frequently embedded in program agreements and third-party partnerships – present complexity. These structures likely require evaluation beyond the accounting guidance for loans captured in Accounting Standards Codification (ASC) 310 or the credit loss framework of ASC 326.
Third-party lending arrangements might provide credit protection, yield protection, or both. As transaction structures and servicing models evolve, financial institutions must determine whether enhancements are embedded in the loan agreement or are in freestanding contracts, as this distinction is critical for applying the appropriate accounting model.
Although the potential nuances of various loan structures are numerous, financial institutions need to determine how to account for these arrangements. Careful evaluation of the contractual arrangements at inception is essential.
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Freestanding versus embedded
Evaluating the accounting treatment for a credit enhancement begins with determining whether the credit enhancement is embedded in the loan or is freestanding as a separate contract.
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Excerpt from FASB Accounting Standards Codification |
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Master Glossary – Freestanding Contract A freestanding contract is entered into either: a. Separate and apart from any of the entity’s other financial instruments or equity transactions b. In conjunction with some other transaction and is legally detachable and separately exercisable. |
Examples of freestanding and embedded credit enhancements
- Embedded credit enhancements are incorporated into the loan agreement with the same counterparty – the borrower. Two common examples are primary mortgage insurance (PMI) and government guarantees. In the case of PMI, the borrower pays for the insurance as a condition of obtaining the loan, while the bank is designated as the beneficiary of the coverage. Similarly, a loan carrying a government guarantee generally requires the borrower to pay a fee or premium for the guarantee, with the lender as the named beneficiary of the guarantee.
- Freestanding credit enhancements are entered into separate from the loan transaction with the borrower and in a way that the guarantee does not “travel” with the loan (that is, the loan can be sold without the credit enhancement). In these arrangements the guaranteed party, not the borrower, is typically paying for the guarantee – whether outright or through a sharing of cash flows associated with the loan.
A lending arrangement where a financial institution originates a loan sourced by a third party or purchases the loan from the third party, with the institution paying the third party a fee or sharing a portion of the cash flows associated with the loan in exchange for the third party providing the credit enhancement, generally meets the definition of a freestanding contract.
Making this determination is an important first step as embedded credit enhancements (that is, credit enhancements that are not freestanding) are considered to be a single unit of account with the loan. Embedded credit enhancements can be contemplated in the estimate for the allowance for credit losses (ACL) under ASC 326.
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Excerpt from FASB Accounting Standards Codification |
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Credit Enhancements The estimate of expected credit losses shall reflect how credit enhancements (other than those that are freestanding contracts) mitigate expected credit losses on financial assets, including consideration of the financial condition of the guarantor, the willingness of the guarantor to pay, and/or whether any subordinated interests are expected to be capable of absorbing credit losses on any underlying financial assets. However, when estimating expected credit losses, an entity shall not combine a financial asset with a separate freestanding contract that serves to mitigate credit loss. As a result, the estimate of expected credit losses on a financial asset (or group of financial assets) shall not be offset by a freestanding contract (for example, a purchased credit-default swap) that may mitigate expected credit losses on the financial asset (or group of financial assets). |
Freestanding credit enhancements cannot be contemplated in the ACL estimate and require separate evaluation, typically under the derivatives guidance within ASC 815.
Derivative evaluation
Third-party credit enhancement arrangements often meet the definition of a derivative under ASC 815 as they generally involve a payment provision, little to no net investment, and net settlement (as the party in a loss position is reimbursed through cash payment from the guarantor). If the agreement is required to be accounted for as a derivative, it is recognized at fair value, with changes in fair value recorded in earnings.
If the agreement is not a derivative in its entirety, the financial institution should evaluate whether the agreement includes embedded derivatives. An example of a potential embedded derivative would be a provision in a servicing contract (that does not meet the definition of a derivative in its entirety) that provides yield protection to the lender.
Financial guarantee scope exception
However, a credit enhancement is not accounted for as a derivative if it qualifies for any of the derivative scope exceptions. Certain credit enhancements may qualify for the financial guarantee scope exception in ASC 815-10-15-58.
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Excerpt from FASB Accounting Standards Codification |
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Certain Financial Guarantee Contracts Financial guarantee contracts are not subject to this Subtopic only if they meet all of the following conditions: a. They provide for payments to be made solely to reimburse the guaranteed party for failure of the debtor to satisfy its required payment obligations under a nonderivative contract, either:
b. Payment under the financial guarantee contract is made only if the debtor’s obligation to make payments as a result of conditions as described in (a) is past due. c. The guaranteed party is, as a precondition in the contract (or in the back-to-back arrangement, if applicable) for receiving payment of any claim under the guarantee, exposed to the risk of nonpayment both at inception of the financial guarantee contract and throughout its term either through direct legal ownership of the guaranteed obligation or through a back-to-back arrangement with another party that is required by the back-to-back arrangement to maintain direct ownership of the guaranteed obligation. In contrast, financial guarantee contracts are subject to this Subtopic if they do not meet all three criteria, for example, if they provide for payments to be made in response to changes in another underlying such as a decrease in a specified debtor’s creditworthiness. |
If the guarantee does not satisfy all of the criteria in ASC 815-10-15-58, the scope exception cannot be applied. If the credit enhancement qualifies for the guarantee scope exception, other accounting must be applied.
Crowe observation: The financial guarantee scope exception is a narrow exception that does not allow for payments to be made outside of the listed criteria. If the third-party arrangement also requires the bank to be reimbursed for losses of amounts not contractually due, the scope exception would not apply.
Crowe observation: In certain arrangements, a waterfall structure is employed that results in the bank sharing a portion of the interest payments with the third party in exchange for the credit enhancement. A careful evaluation of whether this waterfall structure results in the possibility of any payments being made by the third party to the bank for conditions beyond those outlined in the financial guarantee scope exception must be performed. For example, the waterfall might provide the financial institution a guaranteed rate of return that could exceed the contractual interest due on performing loans; such payment provisions would not qualify for the financial guarantee scope exception.
Accounting for credit enhancements that qualify for the financial guarantee scope exception
If a credit enhancement qualifies for the financial guarantee scope exception, other accounting guidance must be applied. The “mirror image” method is a commonly used approach applied by the financial institution receiving the guarantee. The mirror image approach is based on guidance for indemnification assets under ASC 805-20-25-27 and is permitted only when the contract passes the risk transfer test in ASC 340-30 and ASC 944-20. Under this approach, the financial institution records a receivable that mirrors the ACL recognized on the loan. As the ACL is adjusted, an adjustment is made to the receivable to reflect the contractual right to reimbursement under the guarantee. This approach achieves balance sheet symmetry by aligning the recognition of credit losses with the recognition of the guarantee’s benefit.
These other accounting approaches also are allowable:
- Probable incurred loss and recovery method. Under this approach, the financial institution recognizes a recovery asset only when it is probable that a loss has been incurred and the guarantee will provide reimbursement, limited to the amount of the recorded loss.
- Insurance contract claim method. If the credit enhancement qualifies as an insurance contract with substantive risk transfer, the financial institution would record a claims receivable only when the insured event (for example, loss or borrower default) occurs and the recovery of the claims receivable is considered probable.
Looking ahead
As third-party lending arrangements continue to evolve, accurately analyzing the accounting treatment of these arrangements is more critical than ever.
Financial institutions should adopt proactive accounting and legal review protocols and carefully evaluate all of the nuances of the arrangements. Applying the appropriate accounting framework to the legal rights and obligations early in the process can contribute to accurate financial reporting.
FASB materials reprinted with permission. Copyright 2025 by Financial Accounting Foundation, Norwalk, Connecticut. Copyright 1974-1980 by American Institute of Certified Public Accountants.
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