Fair Value and Mark to Market Accounting

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Issue

("MTM", also known as "fair value accounting") has been extremely controversial for many years. Under MTM, certain assets and liabilities are recorded in financial statements at their market values. Therefore, when the market swings, so do financial statements – often ignoring the underlying economics.The current market environment has demonstrated the pro-cyclicality and other flaws relating to MTM.The purpose of this paper is to provide a brief explanation of the flaws of MTM and ABA's recommended solutions.

ABA Position

ABA believes there are situations when MTM can be useful. For example, MTM is appropriate for assets that are held for trading purposes or if an entity's business is based and managed on fair value. In those situations, the expected cash flows and earnings are based on buying and selling in the markets, and MTM can approximate what those cash flows/earnings will be. However, for entities whose business models are not based on buying and selling in the markets, such as traditional commercial banks, MTM provides neither the most relevant nor the most reliable information; it does not necessarily reflect the expected cash flows and earnings; and it will result in misleading the readers of banks' financial statements. Fair value information is already disclosed in footnotes, which are an integral part of financial statements, and footnote disclosure is a more suitable format for providing MTM information.

MTM is required in a number of areas for commercial banks. Investment securities that are traded or are "available for sale" (AFS) are marked to fair value, as is the determination of "other than temporary impairment" (OTTI) on any security.In some cases, the changes in market values are recorded in earnings and capital (such as OTTI), and in other cases the changes in market values are recorded only in capital (such as AFS securities).In any event, MTM has an impact on publicly reported capital.

This market has brought to light two major areas in the MTM literature needing repair:(1) the definition of fair value, and (2) the definition of OTTI.Some suggest that these repairs be made to regulatory capital rules; however, all publicly reported information must be improved as soon as possible.

Definition of Fair Value

Fairly recently, the FASB changed its definition of fair value (SFAS 157), now requiring that "exit price" be used.The new guidance, however, does not provide a framework for applying MTM in illiquid markets.Typical sellers are not selling in these markets and typical buyers are not buying in meaningful volumes.Many holders of assets are, thus, restrained from selling, because they know the economic values of their assets are greater than the distressed sale values they are seeing in the marketplace.Thus, there is no true "fair value".The use of "exit price" in an illiquid market results in an unrealistic downward bias, which reduces transparency and can have serious public policy implications.

Definition of OTTI

Recording OTTI that is based on credit impairment is non-controversial in the banking industry – banking institutions fully understand and support the need to record such impairment. However, there is much controversy with recording losses that are based on the market's perception of value (MTM), which often results in recognizing losses that exceed credit losses or recording losses for securities that have experienced no credit problems and are fully performing in accordance with their terms.The erosion of earnings and capital due to a market's perception of losses or due to a lack of liquidity that drives values lower is misleading to investors and other users of financial statements.The SEC has recognized there are problems with the OTTI guidance and requested in October 2008 that FASB "expeditiously address issues that have arisen in the application of the OTTI model."This project must be completed immediately.

 

In today's illiquid market, the results of improper OTTI rules can be severe:capital is artificially eroded despite solid fundamental credit performance and the lending capability of a bank is reduced as much as $7 for every $1 of needless OTTI.This amplifies the pro-cyclical nature of MTM – reduced lending slows economic activity, which puts borrowers at risk, further pressuring asset-backed security prices.The cycle builds on itself.The resulting misleading information is contributing to the uncertainty in the markets and the further constriction of credit in investment markets.

In the US, OTTI is triggered based on market values and if OTTI exists, the asset must be written down to market value through earnings.That is, if an asset's market value is below the value on the books, it should be evaluated to determine whether it has OTTI.If OTTI exists, then the asset must be written down to market value, and the loss is reported in both earnings and capital.

In the current market, some areas of the market are so uncertain that the market "bid" prices are discounted significantly below the expected cash flows to be received.An example of this is a bank that holds an investment security in its "held to maturity" securities portfolio.The security may have an economic value (the expected cash flows) of 90 cents on the dollar, but the market value is only 50 cents on the dollar. Under the current application of the OTTI rules, even if the cash flows are performing at 90 cents and the entity holding the security has both the intent and ability to hold the securities until the security matures, the entity must write down the security to 50 cents.This write-down is permanent, and there is no subsequent reversal of the loss, even if the asset recovers its market value.And, going forward, reported yields on these investments are disproportionately high.

The example below illustrates these problems.Although it was provided by a large banking institution, the concepts are applicable to banks of all sizes.The bank was required to take an irreversible $913 million loss on a mortgage-backed security, even though estimated cash flow losses on the security are estimated at $100 million.This permanent $913 million loss is over 9 times the estimated lifetime losses.

In the US, OTTI is triggered based on market values and if OTTI exists, the asset must be written down to market value through earnings.That is, if an asset's market value is below the value on the books, it should be evaluated to determine whether it has OTTI.If OTTI exists, then the asset must be written down to market value, and the loss is reported in both earnings and capital.

In the current market, some areas of the market are so uncertain that the market "bid" prices are discounted significantly below the expected cash flows to be received.An example of this is a bank that holds an investment security in its "held to maturity" securities portfolio.The security may have an economic value (the expected cash flows) of 90 cents on the dollar, but the market value is only 50 cents on the dollar.Under the current application of the OTTI rules, even if the cash flows are performing at 90 cents and the entity holding the security has both the intent and ability to hold the securities until the security matures, the entity must write down the security to 50 cents.This write-down is permanent, and there is no subsequent reversal of the loss, even if the asset recovers its market value.And, going forward, reported yields on these investments are disproportionately high.

The example below illustrates these problems.Although it was provided by a large banking institution, the concepts are applicable to banks of all sizes.The bank was required to take an irreversible $913 million loss on a mortgage-backed security, even though estimated cash flow losses on the security are estimated at $100 million.This permanent $913 million loss is over 9 times the estimated lifetime losses.

Recommendation for Improving Financial Reporting

ABA recommends the following:

1. Replace the definition of "fair value" from "exit" price to the price between a "willing buyer and willing seller in an arm's length transaction that is not a forced sale".This is a more representative estimate of fair value.

2. The US model for OTTI should be based on an improved version of international standards. The trigger for OTTI should be credit impairment (probable loss), and the assets should be written down for that economic loss rather than market value loss. Additionally, if OTTI recovers, the write-downs previously taken through earnings should be reversed through earnings.This would provide a more accurate estimate of economic loss.

3. MTM (fair value) should not be the model used to account for all financial instruments, and the current efforts to do so should be abandoned.

These proposals will improve financial reporting by providing users with more accurate loss information.

House Financial Services Subcommittee Hearing and FASB Response

On March 12, 2009 the U.S. House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing on MTM. Among those witnesses were representatives of the FASB, the SEC, the OCC, and others within the lending and investing communities. There was general consensus that changes were needed specifically in regards to MTM in illiquid markets, as well as OTTI, including recording only the credit portion of impairment as OTTI.

FASB responded on April 9, 2009 be issuing Staff position papers to address these situations. In addition to providing a structured approach in determining whether modeled prices (verses market quotes) should be used, OTTI is adjusted by recognizing only credit losses through earnings (while market-related OTTI is maintained only in capital) for those securities management will not be selling prior to recovery. A beginning balance adjustment to capital and retained earnings is required to separate credit losses from market losses on securities held at implementation.

ABA View on the FASB Actions

1. ABA welcomes recognizing only credit losses through earnings, as well as the beginning balance adjustment. We expect recoveries of OTTI will be addressed later this year by FASB.

2.FASB's emphasis on the "exit price" to determine fair value just doesn't work in a distressed market. It gives no consideration for what price a seller is willing to accept and creates a liquidation price where no orderly trades exist.

3. More work is needed by FASB to determine the validity of MTM for institutions, like traditional banks, that have business models that are not based on buying and selling in the markets.

Example of Expected Losses vs. Mark to Market

This real-life example involves a bank that made loans and securitized them as a mortgage backed security (MBS). The bank is required to record mark to market losses of $913 million, as opposed to the maximum expected lifetime losses of $100 million (all of which is absorbed by collateral), resulting in a significant overstatement of losses and having a negative impact on tangible common equity.

MBS Description

  • Total mortgage backed securities equals $3.65 billion as of December 31, 2008.
     
  • The underlying loans are not sub-prime and are generally quality loans (average of approximately 17 months of seasoning, original FICO scores of 749, and original loan-to-value ratio of 73%). 

Losses Based on Mark to Market

  • The MTM write-down on this pool is more than 9 times the maximum estimated lifetime losses. 
     
  • The Bank will not sell the securities at the estimated market value, as the value of the securities and the estimate of cash flows is much greater than the market is willing to pay.
     
  • The Bank attempted to buy similar MBS at a comparable yield and credit quality, but cannot find them at the price the bank is being required to mark them down. This is because "market" quotes the Bank is required to use do not represent the actual cash flow value of the underlying loans.
     

Please contact Michael Gullette for more information.