It appears a cranky FASB, responding to a flood of comments — some ill-informed, a bunch form letters — added a few teeth to what had been looking like a technical fix to other-than-temporary-impairment guidance for securitized assets. Last week the Financial Accounting Standards Board voted to issue FSP EITF 99-20-a, Amendments to the Impairment and Interest Income Measurement Guidance of EITF 99-20, but with additional language not included in the exposure draft. The amendments were rushed through the FASB process over year-end under pressure from the SEC: the Board voted December 15 to issue the changes for comment, staff posted the exposure document December 19, users and preparers of financial statements had until December 30 to comment, and the Board voted January 7. The guidance will be effective for forth quarter earnings reports. In all, over 350 comments were submitted despite the fact the comment period coincided with Christmas Eve, Christmas, Hanukkah, Kwanzaa and New Year’s Day. Based on the exposure document, one would have thought this was a big to-do for a small result. (HousingWire covered the exposure document and a flavor of the first couple hundred comments on January 6. See earlier story.) For one thing, the scope of EITF 99-20 is limited, and that limits any relief it might provide. EITF 99-20 applies to a minority share of the dollar volume of outstanding asset securitizations (classes rated single-A or less, interest-only and residual interests). Moreover, risk-based capital requirements and regulatory oversight would tend to limit investment by regulated financial institutions in these lower-rated classes of securitizations. Briefly, the proposal brought EITF 99-20 into alignment with FAS 115 by replacing language in EITF 99-20 that calls for OTTI to be measured using “cash flows that a market participant would use” with directions to follow the guidance in Paragraph 16, Impairment of Securities, in FAS 115. Some users of financial reports objected to the change on the grounds removing a reference to market participants from anything is a step backwards, away from fair value accounting. To less partisan eyes, it’s simply the kind of change that a standard setter, reluctant to make a change under pressure because the preparer community does not want to recognize losses, would make. It tidies up accounting guidance, eliminates inconsistent treatment for similar assets, and reduces the number of OTTI models for financial instruments in GAAP from three to two. (The remaining model is provided in FAS 114, Accounting by Creditors for Impairment of a Loan.) The changes do not alter the fact that preparers must assess whether the sharp decline in market value of their MBS, ABS, CDO, CMBS and so forth is other-than-temporary. The change doesn’t address a primary target of preparers’ dissatisfaction – current practice under the scant guidance provided for determining OTTI under FAS 115. Boon or bone? To an accounting outsider, the proposed FSP looks less like a boon to banks and more like a bone thrown by the SEC to Congressional and other political forces inflamed by the idea that fair value accounting hurts financial institutions, constrains credit and is deepening the crisis. Indeed, the SEC has already taken bragging rights. In a December 8 speech, chairman Christopher Cox said since October they had been asking FASB to address issues like impairment. He was specific: “the treatment of so-called EITF 99-20 securities including CDOs and other structured instruments. As you will hear from Bob Herz and others later today, the FASB is working diligently on these issues, and is mindful of the importance of providing guidance in time for the preparation of annual reports at the end of this year.” Actually, in his speech FASB chairman Robert Herz did not mention any diligent work on impairment and EITF 99-20. The issue surfaced soon thereafter, however, on the agenda for the December 15 Board meeting, wearing a tight deadline to reflect the looming closing of the books on Year 2 of the disaster. Or maybe Cox was pushing them to meet a deadline the SEC faced under the Emergency Economic Stabilization Act of 2008. When the SEC published its mandated mark-to-market study on December 30, the EITF 99-20 adjustment was listed as a “Financial Reporting Responses to the Global Economic Crisis”. Read the full study. Pushed to it Clearly the Board was not gung ho. The vote was three to two. Herz and Board members Leslie Seidman and Larry Smith voted in favor. On FEI’s Financial Reporting Blog, Edith Orenstein reports that Seidman characterized the amendments as “modest clarification,” with which Herz and Smith concurred. Some comments almost irritated the reluctant Board. According to Orenstein’s account of the discussion, Herz and Seidman were “troubled” by comment letters asserting that, if securities were currently receiving cash flows, “there definitely was no need to take any impairment.” Herz said he “felt the need to remind people, some of their assertions about the way current literature operates is not correct.” That reminder was delivered, in the form of additional clarifying language that will be included in the final FSP. The language was proposed, in the words of the meeting handout, “to avoid any misinterpretation of the removal of the reference to market participants.” The additions:
- Remind entities to consider existing guidance to applying OTTI under FAS 115, and
- Consider all available information, reflecting past events and current conditions, when developing the estimate of future cash flows for determining whether to record an other than temporary impairment. All available information would include, but not be limited to, the remaining payment terms of the instrument and economic factors that are relevant to the collectibility of the instrument, such as current prepayment speeds, the current financial condition of the issuer(s), and the value of any underlying collateral.
- Exercise judgment when assessing whether declines in fair value are indicative of a decline in the cash flows expected from the issuer of the security. For example, an entity should not automatically conclude that a security is not impaired because all of the scheduled payments to date have been received. Nor should an entity automatically conclude that every decline in fair value represents an other than temporary impairment.
This is clarity According to Orenstein, Herz thought this similar to the SEC’s SAB Topic 5-M guidance. This accounting outsider disagrees. The clarifying language is more specific and more pertinent to the impairment issues facing financial institutions now. The caution that not every decline in fair value results in OTTI should discourage any bright line rules (a decline of x percent for y months = OTTI) that have evolved from the SAB Topic 5-M’s direction to consider the extent and duration of the decline from cost. In addition, the “available information” cited sharpens the criteria for determining OTTI in securitized assets in a way that leaves little room for preparers to hide behind the current performance of a security. Remaining payment terms refers to payment resets – the language recommended in the meeting handout goes farther to, state payment terms could be significantly different in future periods for securities backed by nontraditional loans. Relevant economic factors could include a sober estimation of the likelihood of repayment given rising unemployment and continued deterioration, nationally and in many local markets, of home prices. The value of any underlying collateral would refer, in particular, to the residential and commercial real estate securing loans backing impaired securitizations. Houses, that is, that could have declined in value 20 percent or more. And the outlook for commercial properties is dimming as well, with the credit crunch and economic recession. Use models to comply The specificity of this added language should promote the use of valuation models that forecast cash flows based on loan characteristics and economic variables to project the prepayments, delinquencies, defaults and loss severities that determine the collectibility of cash flows. A number of such models exist — from third-party valuation vendors, the broker-dealer research groups still standing, even the rating agencies, who have enhanced and migrated their rating models to business units charged with providing investment evaluation and strategy services. In its comment on the FSP, Andrew Davidson & Co. point out that, owing to their proprietary nature and complexity, “no two models will predict exactly the same cash flows, even under similar economic assumptions. Nevertheless by comparing the results of several models and looking at the historical performance of a model, it is possible to determine the reasonableness of a forecast.” It’s much fairer to ask auditors (some of whom have their own models as well) to make those comparisons than to continue to use rules-of-thumb, though my experience tells me that entities compelled to book losses will dislike the results of this guidance at least as much as they dislike rule-based practices. Some observers of the capital markets train wreck may complain that models helped make the mess, but fact is, models are no better than the assumptions fed them and the bad assumption was that home prices would continue to rise. These same tools are now being used by the slowly emerging cadre of distressed asset buyers to evaluate the break-even, upside and downside on prospective purchases of securities and loan portfolios. That is to say, the models incorporate the cash flows the reviving market will use to project asset performance. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.