Wednesday, October 15, 2008

Fair Value: Current Developments and Long Run Ramifications

EU, IASB Change Fair Value
Rating Agencies Chime in on Fair Value Fight
Today the International Accounting Standards Board (IASB) published proposals to improve the disclosures around financial instruments including fair value measurements of financial instruments and liquidity risk. The changes are described here .

According to the IASB, the proposals form part of their response to the credit crisis and follow recommendations of the Financial Stability Forum, which had the support of the Group of Seven (G-7) Finance Ministers. The proposals also reflect discussions by the IASB’s Expert Advisory Panel on measuring and disclosing fair values of financial instruments when markets are no longer active—see

Sir David Tweedie, Chairman of the IASB, described the proposals this way: “The credit crisis has heightened concerns about liquidity risk and pointed to the need for entities to explain more clearly to the outside world how they determine the fair value of financial instruments, especially those that are particularly complex. The proposals build on the advice we have received from the IASB’s Expert Advisory Panel.”

Meanwhile committee of the European Commission (i.e. the people who run the EU) OK’d the IASB changes to mark-to-market rules. The changes allow firms some flexibility when applying mark-to-market rules where there is no an actively traded market for an asset. This follows guidance released last week by the FASB.

A few excellent articles on the subject of Mark to Market/Fair Value:

Excerpt from a WSJ article on regulation of the financial services industry:

Fair-value accounting
The issue: Should firms, including banks, value their assets at their market prices, no matter how illiquid they are?

The protagonists:
In favor: the International Accounting Standards Board; the Securities and Exchange Commission; accounting firms.
Against: some large banks and brokers; U.S. Republicans, including Republican presidential candidate John McCain; French President Nicolas Sarkozy.

The debate: Fair-value rules became a topic of controversy in Europe in 2005, when all listed European companies adopted International Financial Reporting Standards, which required them to record an extended range of financial instruments such as derivatives and bonds at fair value on their balance sheets. Companies had previously been able to value many such instruments at historical cost, allowing them to avoid the complexities of subjectively attaching a price to abstract or illiquid assets.

Many bankers and political leaders, including Messrs. Sarkozy and McCain, argue that fair-value accounting is exacerbating the credit crisis by requiring companies to report unrealized losses, forcing them to top up their balance sheets through asset sales that debilitate them further.

One reply, frequently made by accounting-standards bodies, is that fair-value accounting is exposing the scale of the problem at a time when transparency is vital. Fair-value also allows for comparisons between companies in the same sectors and gives investors a far better appreciation of risk management than would be possible under cost accounting.

Its detractors also argue that it heaps volatility on earnings. It also places a heavy emphasis on the judgment of a company's management, which ultimately decides on the fair price of the hardest-to-value assets. This means losses that may never be realized can bring down companies that are solvent, while companies can talk up profits that may never materialize. Think of Enron, they say.

Likely outcome: The International Accounting Standards Board is engaged on a project to simplify and replace the most complex fair-value rules after the Financial Stability Forum mandated it to look at the issue in April. It is expected to publish updated guidelines next year.
In the meantime, regulators won't want to indulge banks that are being pilloried for irresponsible behavior. However, international accounting boards have already moved to ease fair-value requirements and rules may be relaxed further until the credit crisis is perceived to be over.

The Financial Stability Forum, the body of central banks and financial regulators coordinating the global response to the turmoil in the credit markets, is also looking into tweaking fair-value rules to soften the forces that push the world economy into booms then busts.
DOMINIC ELLIOT at the Wall Street Journal

Banks: The Fight over Fair Value

S&P Ratings tells why that's a bad idea for financial firms to suspend or change the rules concerning asset markdowns.

The current market disruption has triggered a chorus of complaints from many financial institutions and other market participants about the effect of fair value accounting, including an outcry to suspend or substantially modify the rules. The push to suspend and evaluate the accounting for fair-value measurements is evident in sections of the Troubled Assets Relief Program (TARP) legislation. The concerns relate primarily to accounting rules that force financial institutions to value securities at what they believe are overly depressed prices that do not reflect their true value. Further, they contend that reporting these depressed values has resulted in a loss of market confidence that has further exacerbated the current credit market disruptions.

This may seem to imply that fair-value measures should be dispensed with altogether. To the extent that fair-value accounting guidance is suspended or modified, in the absence of addressing analytical needs through greater disclosure and transparency, Standard & Poor's Ratings Services would view these changes as a significant step backward. However, we do believe the recently issued Securities & Exchange Commission and Financial Accounting Standards Board (FASB) guidance, which clarifies how companies should determine fair-value measurements in light of the current market conditions, is helpful.

We recognize that accounting for assets and liabilities at market prices can produce results that could mask the underlying economics for certain businesses and activities, especially during volatile and uncertain economic and market conditions. Yet, we believe the limitations inherent in fair-value accounting do not detract from the usefulness of fair-value measurements in providing a consistent starting point in analyzing financial statements. Rather, the imperfections underscore the need for financial statements to complement fair-value measures with additional information about uncertainties in the measurement of assets and liabilities. Thus, we recommended that certain refinements to fair-value accounting and disclosures be considered.

Fair Value: How Useful?
In the wake of the recent market stress, some market participants question whether fair value provides useful information for investment and credit decisions. Company executives contend that the performance measures produced using fair value create financial reporting that is misleading and disconnected from the reality of their business activities. They also say it creates unjustified and unexpected economic effects, including covenant and regulatory capital stress and liquidity shocks.

Further, there are bank analysts who don't agree that marking loans to market is the best way to assess loan portfolios because it presents a view of the portfolio valuations without giving effect to the expected future earnings that would help cover potential losses.
Many critics have faulted fair-value accounting for creating a spiral of declining valuations arising from forced asset sales. For many financial institutions, mark-to-market losses—coupled with the triggering of significant margin and regulatory capital calls—have forced rapid asset liquidation, exacerbating the loss of value, diminished counterparty confidence, and constrained liquidity.

Recent distressed asset sales by
Lehman Brothers Holdings (LEH), Merrill Lynch (MER), and other distressed asset portfolio sellers set a precedent concerning asset valuations; the actual prices became benchmark prices for real-estate-backed assets and other asset classes. Lehman announced gross mark-to-market losses approximating $7 billion on residential and commercial mortgage-related positions immediately preceding the company's downfall. The impact of these marks on Lehman's financial results contributed to intensified efforts to offload its exposure in residential mortgages and commercial real estate loans and other less-liquid asset exposures.

Merrill Lynch sold a substantial majority of its collateralized debt obligations, incurring a $4.4 billion pretax loss (a 40% decline in its mark in a matter of weeks) in an effort to enhance the company's capital position and reduce risk exposure. The rapid and extreme portfolio devaluations that ultimately contributed to Lehman's failure and Merrill Lynch's loss of independence also became observable inputs for fair-value pricing by other financial institutions.

Also momentous was
American International Group (AIG) capital raise of approximately $20 billion by the second quarter of 2008 to replace essentially all of the capital lost in the preceding two quarters because of market valuation losses and other-than-temporary impairments on mortgage-related securities. During the third quarter, however, liquidity demands increased, leading to AIG's unprecedented $85 billion secured loan facility agreement with the Federal Reserve on Sept. 16, and a subsequent securities lending agreement providing an additional $37 billion in liquidity.

The challenges faced by market participants struggling to determine representative fair values in volatile and illiquid markets, in the absence of further guidance, would have stressed any financial reporting system.

Proponents of reforming fair-value measures look to influence the U.S. Congress, the SEC, banking regulators, and accounting standard-setters, asserting fair-value accounting is faulty. They assert this is largely because of inadequate guidance and the impact of FASB Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157) on financial instrument valuations in distressed or illiquid markets. Similar calls are echoed globally.

The SEC and the FASB recently responded to this call by issuing guidance clarifying practical issues surrounding the application of SFAS 157 in determining market prices. We believe the additional guidance is helpful in clarifying the application of fair-value accounting during periods of market illiquidity. Yet, many other market participants call for the suspension of fair-value accounting altogether.

The recent SEC and FASB guidance emphasizes that fair-value measurements and the assessment of impairments are subject to significant management judgment. As a result, it reiterated the need for clear and transparent disclosures to provide investors with an understanding of the significant judgments management has made. In addition, the SEC issued letters in March and September providing further guidance and requesting enhanced disclosures surrounding fair-value measurements. The FASB has also taken steps to clarify how the fair value of a financial asset should be determined when the market for that asset is not active.

The SEC and FASB clarifications will potentially ease the greater weight placed on values derived from current market transactions for the valuation of similar or identical positions when markets are less active or distressed. Broadly, all other things being equal, we believe the effects of this guidance on financial institutions may increase GAAP [Generally Accepted Accounting Principles] equity and regulatory capital. There might also be a short-term earnings boost through a mark-up for some previously written-down assets, as values are based on greater use of intrinsic valuation assumptions.

Congress looks to the SEC
Section 132 of the TARP gives the SEC broad authority to suspend the use of SFAS 157 by issuer class or category of transaction, if it deems it necessary or appropriate in the public interest, and is consistent with the protection of investors. Section 133 requires the SEC—in consultation with the Federal Reserve Board and the Treasury—to study and report to Congress on SFAS 157 adoption and implementation and the impact to the markets within 90 days. It includes studying the impact and effects of SFAS 157 in the context of:
• A financial institution's balance sheet;
• Bank failures in 2008;
• The quality of financial information available to investors;
• The process used by the FASB in developing accounting standards;
• Advisability and feasibility of modifications; and
• Alternative accounting standards to SFAS 157.

The nature or extent of disclosure that would be required in the suspension of SFAS 157 or the absence of its disclosure requirements is unclear. However, suspension of the guidance could result in market participants questioning valuations. Under these circumstances, it seems analysts and investors will view the resulting valuations with greater skepticism, resulting in further erosion of investor confidence in valuations that could complicate recent efforts to stabilize the capital markets.

We reiterate our belief that fair-value accounting should continue to have a significant role in the accounting for financial assets and liabilities but that it should be reinforced and enhanced with more informative disclosures and revisions to the income statement to achieve desired financial reporting objectives.

To succeed in improving fair value measurement guidance, active participation and contributions by all affected constituencies (including companies, accounting standard setters, auditors, investors, regulators, and analysts) is essential. This ultimately could lead to an improved financial reporting discipline that will be capable of meeting the information needs of investors and creditors, and of supporting the evolving global capital markets, under varying economic conditions, for many years to come.
Joyce Joseph-Bell, Ron Joas, and Neri Bukspan From Standard & Poor's RatingsDirect

Rating Agency Believes Future Impairments May Overshadow New Fair Value Guidance for U.S. Life Insurers
Recently, the SEC and FASB issued a joint statement (1) 'clarifying' guidance on mark-to-market rules for valuing balance sheet assets in the current market environment. The new guidance essentially gives management discretion to use their own estimates (Level 3 in the fair value hierarchy (2) in those cases where market observations (often classified as Level 2 in the fair value hierarchy) do not reflect orderly transactions in this illiquid market. However, management estimates must incorporate current market participant expectations of future cash flows and include appropriate risk premiums, which Fitch believes may limit any significant benefit in valuation.

Companies - including U.S. life insurers - have typically marked-to-market structured securities using broker quotes or related index pricing on a GAAP or IFRS basis, which has led to significant unrealized losses reflected on the GAAP/IFRS balance sheet as a reduction of shareholders equity. Although this guidance may be considered potentially positive from a current valuation perspective, any benefit could be overshadowed by the aging of existing unrealized losses on structured and other securities that may need to be recognized as other than temporary impairments (OTTI), in Fitch's view. Thus, the clarifying guidance may not ease future capital pressures for U.S. life insurance companies, and such potential capital pressures continue to support Fitch's Negative Outlook for U.S. life insurance ratings.

On a U.S. statutory basis, impairments have been moderate through the first half of 2008 due in part to the less onerous nature of statutory impairment tests for structured securities relative to GAAP/IFRS. Therefore, many insurers have recognized impairments on a GAAP/IFRS basis, but not on a statutory basis - this is an important distinction. Under statutory accounting principles, most bonds are carried at amortized cost. Under GAAP/IFRS, most bonds are carried at fair value. Fitch believes that over the next several quarters insurers will more closely align their statutory impairment practices to GAAP/IFRS as new regulatory guidance is introduced. This will likely mean increased statutory impairments. Therefore, Fitch believes that current statutory capital for the industry is overstated relative to economic capital due to the less onerous accounting for structured securities.

Under the SEC/FASB guidance, companies could measure fair value for structured securities using a discount of expected cash flows, which in Fitch's view is an approximation of true economic value of the securities. In Fitch's opinion, expected cash flows from certain tranches of residential mortgage backed security (RMBS) portfolios originated in particular years may be higher than the current market value indicates. Fitch also believes that expected cash flows from certain pockets of exposure are susceptible to significant losses - particularly Alt A and subprime RMBS originated in 2005, 2006 and 2007. OTTI on these securities should reflect the high level of losses expected.

The Troubled Asset Relief Program (TARP) may set future market prices for structured securities that will be used by all market participants regardless of participation in the program. This would constitute a Level 1 valuation in the fair value hierarchy that would supersede management's estimates.

In the near term Fitch believes RMBS market illiquidity is manageable. As long as life insurers have sufficient liquidity to meet near-term policyholder obligations, they can hold RMBS securities on their balance sheets. Life insurers' risk management programs typically include strict asset/liability matching of durations. In most cases, life insurers average liability durations are between 5 and 10 years, which gives life insurers flexibility in buying and selling securities when managing their investment portfolios. However, if market illiquidity persists and/or policyholders lose confidence in the industry, assets may have to be liquidated sooner than expected and at a significant loss. Regardless of market liquidity, if material cash flow losses begin to emerge on these securities, then the life insurance industry's capital adequacy will be adversely affected.
(1) The joint statement from the SEC and FASB on Sept. 30, 2008 was confirmed in a FASB Staff Position paper released on Oct. 10, 2008.
(2) The fair value hierarchy is described in FASB Statement No. 157, Fair Value Measurements.

SOURCE: Fitch Ratings

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