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Impairment Tug Of War: Management Wins First Contest Over Valuations
Asset Securitization Report--SourceMedia (January 12, 2009)
The Financial Accounting Standards Board (FASB) narrowly decided Jan. 7 to approve an amendment allowing holders of securitized assets to consider factors besides fair value to determine whether to report losses in those investments.
Dissenting board members expressed concern that the move could permit public companies to defer reporting fair value losses - as many have done over the last two years - until they require drastic action, to the dismay of their investors.
In a three-to-two vote, which included Chairman Robert H. Herz in the majority, FASB approved EITF 99-20-a, an amendment to EITF Issue No. 99-20. The original language by the Emerging Issues Task Force (EITF) provides guidance on how to recognize interest income and impairment - reduced asset value - for securitized assets rated below 'AA.' The amendment brings 99-20 closer to Financial Accounting Standard 115, Accounting For Certain Investments in Debt and Equity Securities, by allowing asset holders to apply several factors to determine whether assets are "other than temporarily impaired" (OTTI). Losses for assets found to be OTTI are reported in quarterly income statements and charged against capital, which is potentially problematic for many capital-challenged financial services firms.
The accounting change follows several months of financial turbulence in which the credit markets have been virtually frozen and values of currently illiquid assets, including highly rated securities, have plummeted.
The EITF, a panel created by FASB to address timely accounting issues, published the proposal Dec. 19 and comments were due Dec. 30. The date was set in an effort to reach a decision that would apply to companies reporting fourth quarter and annual income numbers.
During the meeting, Herz noted that the urgency was sparked by skyrocketing interest rates in the fourth quarter. Interest rates have receded somewhat for higher-rated credits, but have nevertheless pummeled values of securitized assets, at times seemingly regardless of whether those securities' cashflows are healthy or not.
Despite the comment period's unusual timing, over Hanukkah and Christmas, the proposed amendment garnered more than 280 comments, although the vast majority were boilerplate comments from community banks echoing the more elaborate argument set out by the American Bankers Association (ABA) in favor of the amendment.
Major banks such as Wells Fargo and BNY Mellon also submitted comments supporting the proposal. Echoing FASB's split vote, they represent one pole that favors relying at least in part on management's judgment whether their firms' holdings have been impaired, along the lines of FAS 115.
Favoring the Original
The other pole favors the original 99-20 language, which relies entirely on market participants' assumptions regarding assets' future cash flows, rather than including management's judgment. That pole comprises mostly investors, who, over the last year and a half, have routinely seen their investments - often in financial firms - plummet in value, even though those companies' financial statements gave little indication of the danger in store.
"Fair value accounting with robust disclosures provides more reliable, timely, and comparable information than amounts that would be reported under other alternative accounting approaches," wrote Jeff Mahoney, general counsel of the Council of Institutional Investors (CII), in a comment letter. The CII represents more than 140 public, corporate and union pension funds with combined assets of over $3 trillion.
Mahoney later noted in an interview that 99-20 "focuses more on a market perspective of value" compared with the "company specific perspective" of 99-20-a, "so it's more of a fair value approach."
CII represents major institutional investors that millions of investors are counting on to fund their retirements, and would seem to have the support of the Securities and Exchange Commission (SEC). Congressionally-Mandated Study Says Improve, Do Not Suspend, Fair Value Accounting Standards reads the headline of the SEC's Dec. 30 announcement about its chief accountant's recent analysis of impairment accounting. In its sixth recommendation, the report noted, "General-purpose financial reporting should not be revised to meet the needs of other parties if doing so would compromise the needs of investors."
That statement would appear opposed to an impairment shift in financial statement preparers' favor. However, the regulator also recommends additional guidance to illuminate "When observable market information should be supplemented with and/or reliance placed on unobservable information in the form of management estimates."
In approving the amendment, FASB is providing management with the power to judge whether securitized assets held by their firms will remain healthy and provide cash flow through maturity, reaching full value. Leslie F. Seidman, who, along with fellow board member Lawrence W. Smith, also supported the amendment, noted that like FAS 115, the amendment requires management to consider additional factors affecting asset impairment. Those factors include fair value as well as the remaining payment terms of the asset and economic factors that are relevant to the collectability of the instrument, such as current prepayment speeds, the current financial condition of the issuer(s), and the value of any underlying collateral. In addition, the financial statement preparer should consider whether it can hold the asset to maturity or may have to sell it sooner, at an impaired price.
"Management has to use its judgment here: Just because a security is currently performing well, it doesn't mean it won't have impairment later," Seidman said. "I don't think this represents amnesty [from reporting impairment]. It still requires an assessment on the collectability of cashflows."
FASB's amendment will make that requirement an emphasis. The concern, however, is that some financial statement preparers have yet to apply FAS 115's similar impairment language as intended, and instead have used the guidance's more subjective factors to their advantage.
Marc Siegel, who, along with Thomas J. Linsmeier, dissented from FASB's decision, said there have been few defaults among commercial real estate loans backing securitizations, resulting in few impairments on those assets to date. But many of those loans' payments balloon later in their terms, and the market is now starting to show alarming cracks.
"It's not surprising that defaults to date are low and the assets are still performing, but when principal payments come due, they will be increasingly difficult to refinance," Linsmeier said, suggesting investors in CMBS have failed to consider enough factors when analyzing for impairment.
Herz and Seidman agreed that too often management analyzes how assets are currently performing, and that is insufficient to determine impairment. "I think it's important we emphasize [in the amendment] ...that current performance is not the test," Herz said.
Even if 99-20-a emphasizes the need for more thorough impairment analysis, introducing management's judgment into the equation may cloud financial statement transparency. Linsmeier and Siegel were skeptical that, given the dire straights many financial institutions find themselves in today, relying on management's judgment would prove beneficial to investors.
FAS 115, which applies to 'AA'-rated securitizations and above and other types of debt, has been around since the early 1990s, and yet little appeared in financial firms' financial statements to forecast the widespread financial calamity that sprang up last year. "How long did it take for deterioration in subprime loans to be recognized in income?" questioned Lensmeier in his dissent. "It was multiple quarters."
Some comments were even more to the point. Jack Ciesielski, a member of the Investors Technical Advisory Committee (ITAC), which provides FASB with independent advise from investors' perspective, noted that "the current market environment induces management of companies to promote new ways to avoid reporting known losses and thereby bolster their capitalization through manipulating or introducing hasty changes to financial reporting." He added, "One such strategy for avoiding reporting losses on financial instrument holdings is to change the impairment testing rule."
Fair Value Accounting Issues
The amendment to 99-20 comes at a time when FASB is dealing with several issues involving fair value accounting and impairment. One issue is merging the at least three separate approaches to impairment currently in the U.S.'s generally accepted accounting principles (GAAP), a goal the amendment furthers by bringing impairment in 99-20 closer to FAS 115. However, FAS 115's impairment version moves further away from fair value, defined as market participants' view of future cash flows that typically are reflected by their bids and offers for the securities.
"The FASB has received considerable feedback from the investment community indicating that they prefer fair value measures of financial instruments," noted Sarah Deans and Dane Mott, accounting analysts at JPMorgan, in a recent report. "Moving from the 99-20 trigger to the weaker FAS 115 trigger actually moves the measure of these assets further away from fair value and makes their OTTI determinations more subject to gaming, in our view."
That's problematic also because FASB is seeking to bring its standards closer to those of the International Accounting Standards Board (IASB), which has taken a strongly fair value approach. Long-term, accountants and most market participants agree that fair value provides investors with more accurate information about borrowers' financial health. And indeed, most if not all FASB members appear to agree that fair value for all financial instruments is their ultimate goal.
However, the current credit freeze has "dislocated" markets, according to Scott Stengel, a partner at Orrick, Herrington & Sutcliffe, resulting in slashed values for even highly rated securities that are performing well and are unlikely to face cash flow issues. Should the holders of those securities have to record impairment for assets if they plan to hold them to term and realize their full value? Referring to the amendment, Stengel said, "It's all really a debate about what assets in dislocated markets are worth. ...It's about 99-20 running up against an irrational market that's paralyzed."
In such markets, some assets may experience few if any trades, with only brokers casting out bids and offers to test the market, providing specious quotes to determine fair value. That argument works in favor of introducing financial-statement preparers' judgment into determining asset values. In FASB's Dec. 15 meeting, however, Linsmeier said financial statement users uniformly told FASB that fair value, while not perfect, is still the best measurement attribute in turbulent markets.
Linsmeier noted that among the 17 banks closed last year between Jan. 25 and Oct. 31 by the Federal Deposit Insurance Corp., the net assets required to be carried at fair value represented just 10% of the banks' total assets on average. He added that banks' unwillingness to loan to each other, and two banks recently purchased in non-forced sale transactions for around 30% of book value, suggested a general distrust of reported asset values on banks' financial statements, "perhaps explaining the illiquidity in current markets."
He said that fair value, if augmented by additional disclosures about judgments and uncertainties in fair value measures, could provide adequate understanding of where losses lie, leading markets to become more liquid. "If anything, accounting is contributing to our problems by providing insufficient information to identify which financial institutions are likely to survive this crisis, leading to a total crisis in confidence in markets and a market psychology that views all banks as extremely troubled, further depressing market prices," Linsmeier said.
In fact, Herz, who acknowledged his support of the amendment was prompted largely by the severity and uniqueness of the current financial crisis, has openly referred to impairment as "voodoo" accounting.
Cielsielski noted in the ITAC comment that accounting for all financial instruments at fair value, accompanied by robust disclosures, would have eliminated "the need for the proposal because other-than-temporary impairment (OTTI) models would not be necessary if all financial instruments were reported at fair value."
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