Sympathy for the Fair Value Devil?

On Wednesday, the Financial Accounting Standards Board is expected to vote on a change to the rules governing guidance for certain beneficial interests in asset securitizations. FSP EITF 99-20-A would amend rules for “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Assets” (issued as an Emerging Issues Task Force 99-20 guidance, effective after March 15, 2001). Normally, even small changes to accounting guidance can take FASB months or years to bring forward — and usually require comment periods of at least 15 days. But this change was proposed on Dec. 15, and the Board agreed to issue an exposure draft (reluctantly, according to many accounts of the open meeting) under an expedited process to make the new treatment available for reporting of the final quarter of 2008. Given the timetable, the draft was released Dec. 19, and comments closed Dec. 30. The rule was rushed through the FASB process apparently at the bidding of the Securities and Exchange Commission. For example, last October, in the course of resolving impairment issues created by the hybrid (debt-equity) nature of perpetual preferred securities, SEC Chief Accountant Conrad Hewitt asked FASB to “expeditiously address issues that have arisen in the application of the OTTI model in Statement 115.” Unhappiness with current OTTI (other-than-temporary impairment) guidance has been a persistent theme at recent roundtables on fair value accounting held by the SEC (pursuant to performing a study of mark-to-market accounting under Section 133 of the Emergency Economic Stabilization Act of 2008), and on issues raised by the credit crisis held jointly by FASB and IASB. Multiple, inconsistent models exist for determining whether a financial instrument is other-than-temporarily impaired. Worse, because holders are required to write an OTTI security down to fair value, the loss taken through earnings (and against capital) includes wide liquidity spreads and adverse interest rate changes, which could reverse during the anticipated holding period, along with any actual credit impairment. The proposal eliminates language in EITF 99-20 that incorporates “cash flows that a market participant would use” in the procedure for measuring OTTI. Instead the holder is directed to follow the guidance in paragraph 15 of FAS 115. In other words, confusion has been reduced. But the impact of the change is likely limited. First, the scope of EITF 99-20 is limited to regular interests in securitizations that are rated single-A or lower, interest-only interests and residual interests. Except for the residual interests held by large banks that sponsored private MBS and ABS, or interests brought back on the balance sheets of institutions that sponsored ABCP, SIV and other types of structured financing conduits, exposures to EITF 99-20 securities in regulated institutions should be limited by risk-based capital requirements. The larger problem for banks, insurers and other regulated institutions lies with higher rated (at least at issue) MBS, ABS, CDOs and beneficial interests that were always within the scope of FAS 115. And paragraph 16 of FAS 115 offers only this criteria for determining if an impaired security (fair value below amortized cost) is OTTI:

For example, if it is probably that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.

More detailed guidance is available from the SEC. Management should use all available evidence to determine the realizable value of an investment, including “the length of time and the extent to which the market value has been less than cost.” Reflecting this guidance, accountants and audit firms have developed bright line rules along the lines of “x percent decline for y months.” Additional information — an actual downgrade, for instance — might also be used. But in the current environment, steep declines in price from original cost are treated as evidence from market participants that credit risk has risen, and/or that the probability that amounts due will be paid has declined. A couple of comments on the proposed changes, including a detailed letter from Wells Fargo, give examples of losses created by presuming OTTI from fair values derived from illiquid markets. For instance, Wells cites a triple-A class of a collateralized loan agreement (CLO) with credit support of 30 percent provided by subordinate classes. Moreover, 33 percent of the collateral is currently in cash. With only one credit in default, the cumulative default rate is 0.8 percent, and the resultant loss rate expected to be 0.4 percent. The November month-end broker mark was 22 points, for a 33 percent yield — levels that would automatically would trigger OTTI by independent auditors and result in roughly an 88 point write down (assuming the bond is a floater, acquired close to par). Over 250 comment letters were received by the deadline, despite the fact that the comment period coincided with Boxing Day, Hanukkah, Kwanzaa, Los Posadas, Christmas Eve and Christmas Day, as one opponent, the Council of Institutional Investors noted. A small minority objected — typically on the grounds that the changes are a step back from fair value accounting, and the process did not allow an adequate comment period. Supporters were overwhelmingly banks, many sending substantially the same letter asserting the change is merely “a first step.” A second step — at least from the point of view of financial institutions grappling with OTTI — is now on FASB’s agenda. At the Dec. 15 meeting, FASB also agreed to consider whether previously recognized OTTI losses on debt securities classified as held-to-maturity and available-for-sale could be reversed through earnings. This would more closely align impairment accounting for securities with that provided for loans and for held-to-maturity securities under International Financial Reporting Standards. 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, and writes regularly at Market News International.

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