New FASB Proposals Released
The FASB released two proposed accounting standards on Wednesday, 5/26/2010:
Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities—Financial Instruments (Topic 825) and Derivatives and Hedging (Topic 815)
Comprehensive Income (Topic 220): Statement of Comprehensive Income
The significance of the two proposals are that they would require virtually all financial instruments to be recorded at fair value on institution’s financial statements. This would be a radical change to existing financial reporting for lending and depository institutions and an unpopular one for the affected institutions. FASB recognizes this and the significant implementation issues and currently recommends an adoption date of more than 5 years for smaller institutions. The required adoption date for larger institutions is not yet determined.
Two of the five FASB Board members had some significant differences of opinion on the proposed standard.
The appropriate accounting for financial instruments has long been debated by the FASB and these current proposals are a part of a joint project the FASB originally started in 2005 with the IASB.
The two proposals can be found here:
Comprehensive Income (Topic 220): Statement of Comprehensive Income
Comment letters are due by September 30, 2010.
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FASB Update
While there are some in the media that are suggesting this is a sudden reversal of the decisions made last April, it is actually part of a process that started years ago. Both the FASB and the International Accounting Standards Board (IASB) have a long term stated objective that the primary accounting for ALL financial instruments including liabilities should be fair value. They are now in the first steps of a very long process on how to exactly do this.
The initial recommendation is that fair value be the default accounting for financial instruments on the balance sheet. However, other factors such as the institution’s business model (buy and hold versus trade, for example) and characteristics of the financial instrument (cash flow volatility, derivative, market activity), along with other factors will determine whether the unrealized gain or loss is recorded in the income statement or the balance sheet via other comprehensive income. These determining factors have not been laid out in detail yet as they are at the conceptual stage. It very well may be that they are the same concepts used now for securities (primarily based on intent) with a few twists. What is happening now is the first step in a long process on the best way to do this, which includes seeking comments from the industry. The ABA came out quickly with a letter to the FASB with their opinions.
This is an important issue that we will follow closely and may ultimately result in significant changes to accounting for financial instruments. It will also probably force regulatory changes to capital requirements and calculations. However, it is not a sudden reversal of the April decision that changed how fair value is determined in inactive markets or how it is used for impaired securities. It simply is the first step in implementing a long stated common objective of the FASB and IASB.
As fair values become more part of the accounting process for less active financial instruments, it will put more of the spotlight on pricing models that value credit such as loans. I’m very curious to see if the loan fair value models used by many big banks that resulted in fair values of their entire loan portfolios (including commercial, construction, land development loans and consumer) in the high 90s for the last several quarters receive a little more attention.
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FASB Modifies MTM!
FASB met this morning as Bloomberg reported in FASB Eases Fair-Value Rules Amid Lawmaker Pressure. Of interest is the new OTTI guidance added a provision that would allow financial institutons that previously recorded an OTTI charge to reclassify the non-credit portion of the charge from retained interest to other comprehensive income. This directly increases Tier 1 Capital. This was not in the FSP but we asked for it in our comment letter along with many others.
For example, the FHLB Atlanta which took a 87 million dollar charge for a 44,000 credit loss will now be able to reclassify 86.56 million into capital (unless credit losses have increased since then).
Click here to download a copy of the article.
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Rich Berg Testifies to House Committee on Financial Services
The House Committee on Financial Services is holding a hearing entitled, “Exploring the Balance between Increased Credit Availability and Prudent Lending Standards”. The morning session included testimony and question and answers from the top regulators from the Federal Reserve, FDIC, OCC, OTS and the SEC.The afternoon session consisted of testimony from various community bankers, representatives of banking organizations and Rich Berg who all discussed how the credit crunch was effecting the market. Rich Berg focused on how the current credit rating system consisting of a single letter grade is hard coded in investment policies, regulatory policies, and counterparty agreements and is limiting credit. This single letter grade is exaggerating the risk of multiple-obligor securities removing all the natural buyers of the securities and further depressing the market prices. This also takes away market incentives for new securitizations.
Full testimony from all witnesses is posted on the House Committee on Financial Services website. Please read Mr. Richard S. Berg’s testimony to the committee - final witness on Panel Two.
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Committee on Financial Service Hearing to Discuss CREDIT
Right now, the Committee on Financial Services is holding a hearing entitled, “Exploring the Balance between Increased Credit Availability and Prudent Lending Standards” in Washington. The discussion centers around legislative, regulatory and other obstacles that financial institutions feel are limiting their ability to provide credit. In addition to accounting obstacles discussed on this blog, many bankers feel there are regulatory hurdles that make lending more difficult than it should be given the market conditions.
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Criticism of FASB Proposal Unfounded
The FASB released two proposed staff positions (FSPs) on Tuesday as expected to provide application guidance on determining fair value in inactive markets and on accounting for securities that are other than temporarily impaired. The FASB is seeking comments through April 1st on both proposals with the goal of finalizing at an April 2nd board meeting.
Information from the FASB and the FSP’s on the process can be found here:
http://www.fasb.org/news/nr031709.shtml
The two proposals can be found here:
http://www.fasb.org/fasb_staff_positions/prop_fsp_fas115-a_fas124-a_and_eitf99-20-b.pdf
http://www.fasb.org/fasb_staff_positions/prop_fsp_fas157-e.pdf
Jonathon Weil wrote a commentary for Bloomberg on March 18th titled “Accounting Brothel Opens Door for Banker Fiesta” where he calls the new FSP’s the dumbest, most bankrupt proposal of the “Fraudulent Accounting Standards Board’s” 36 year history. However, the basis for his conclusion is based on a misinterpretation of the proposals. Weil writes, “So, if these rules had been in place last year, a company that still owned shares of AIG or Fannie Mae, for instance could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or they are both penny stocks. The loss would get buried away from the income statement, in a balance sheet-sheet line called “accumulated other comprehensive income.”
This is wrong. Actually, any loss related to an other than temporary impairment (OTTI) stays right on the income statement in the new proposal. In fact, the new proposal provides more transparency as the components of the loss are broken out between credit and non-credit components. Any investor would certainly find that information more meaningful. Read more
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Today’s FAS Hearing – LIVE
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Determining whether a market is inactive and whether transactions are distressed for the purpose of determining the fair value, and
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Readdress the impairment model for credit losses with 5 or so options
A quick look suggests the recommend proposal (Option B) by the staff is positive (but the Board could reject).
Won’t be effective until March 31st so people in the middle of the audit for 12/31 may not get the benefit.
There has been discussion going on about the rating process and its effect on supply and demand (I missed the beginning) and Triple C bonds, so it suggests they heard our point from last week.
More to follow.
Link to meeting going on: http://fasb.trz.cc/live.php
Handout: http://www.fasb.org/board_handouts/03-16-09.pdf
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I agree, HOWEVER…
Recently, there was a very insightful op-ed article in the WSJ, [$$] How Geithner Can Price Troubled Bank Assets by Peter J. Wallison, involving the difference between the value of what mortgage-backed securities are trading at and the value of their cash flows. The conclusion drawn by Mr. Wallison is that since the net realizable value of the cash flows exceeds the market bids for the securities due to the distressed and illiquid market, the government can purchase the assets at the net realizable value and still be a net benefit to the taxpayers and the bank. The US can hold the securities and earn a positive return and the banks can free up their balance sheet without impairing their capital. The classic win-win. Mr. Wallison argues that no major accounting policies need to be changed, as the seller could liquidate their positions at a price they feel represents the value and not significantly reduce their capital. We don’t disagree. However, the same could be accomplished without major changes to accounting standards, but providing simple clarity to the existing accounting standards. Mr. Wallison writes the following: Read more
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“Mark-to-Market Changes Fail to Rally Stocks” Why not?
The FASB recently announced a new project to improve the fair value measurements and disclosures of financial instruments. This was expected and is in response to recommendations from a SEC study on mark to market and input from the FASB’s Valuation Resource Group. The article, Mark-to-Market Changes Fail to Rally Stocks, notes that the announcement did little to move the market as “its promise has been thwarted by government initiatives that could actually prevent a market recovery.”
More significantly, it did not spark a market rally as the measurement of fair value is not the primary concern among financial institutions. The primary concern is when they are required to mark assets down to fair value and that is when the asset is deemed to be Other Than Temporarily Impaired, or OTTI. One of the misunderstandings in the media and general public is that a new accounting rule (SFAS 157) requires every asset to be marked to market. SFAS 157 was issued in 2007 but only provides guidance on how to measure fair value. Other accounting standards already in place determine when an asset should be marked to market and some of those reasons include whether an asset is placed in a trading account or whether it is held for sale or if they are determined to be OTTI. SFAS 157 did provide the OPTION to use fair value for most financial assets but very few institutions chose that option because of the earnings volatility it would cause. And this was understood even before the credit crisis.
Today, financial institutions hold mortgage-backed securities that despite the real estate market are backed by a substantial percentage of performing mortgages. Further, many of these securities are senior securities that won’t incur a loss until a junior security has absorbed all the losses in the trust. However, many of these securities are trading at significantly discounted prices due to a combination of real credit fear and the accounting rules. If cash flow projections indicate a probability of even a minor dollar loss on the security in the future, the accounting rules could consider the security OTTI. But instead of writing off the projected dollar loss, accounting rules require you to write it down to fair value which in a distressed market can turn a $5 dollar loss into a $10,000 dollar loss. Read more
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