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.

Weil also suggests that under these rules, banks that hold shares of Fannie Mae would not be required to write those shares down to net income. This would only be true if they believed they were going to get all their contractual cash flows of the security back. Given that the accounting industry has banned Bernie Madoff’s accountant, David Friehling, from auditing, I don’t think you would find an accountant that would that accept that assertion.

In summary, the proposals will not change the carrying value of the security, the loss disclosed on other securities that are OTTI on the income statement, OR the reported capital on the balance sheet. It also doesn’t change significantly the way a security is determined to be OTTI. The only thing that changes is the amount of Tier 1 capital for regulatory purposes if you have a security that is OTTI. The loss related to non credit reasons is excluded from the Tier 1 capital calculation and thus, would increase the lending capacity of a bank.

“Mark to market” is the mainstream term for the accounting issues facing financial institutions today but the issues are a little more complicated than the mainstream debate which centers on “the new rule that requires all banks to write their loans and securities to market”. Many bankers have joked that during this last year they have all been forced to become accountants to better understand the issues. Journalists are trying to do the same and catch up in 6 months with the 5 board members of the FASB who have probably over 100 years combined dealing with these issues. If you listen to the board members debate over the proposals (which you can here )http://craig.teamline.cc/fasb_archive3 , you will walk away impressed with not only their grasp of the issues but how they debate them.

The “mark to market” issues are less about accounting and more about the interrelation between credit rating, accounting, and regulatory policies. Many residential mortgage-backed securities have real credit issues but the policies have created so many obstacles that virtually all buyers have been eliminated accelerating the pricing pressure on the securities. A trillion dollar + market has been orphaned and consequently many securities are trading far below intrinsic values. Until these issues are fixed, the securitization market will remain stalled. The FASB’s proposals are one positive step in this process.

The accounting rules relating to assets such as mortgage-backed securities require that they be marked to market if they are held for trading, or in a category called “available for sale.” Most banks hold these assets in one of these two accounts, and so mark-to-market rules apply. What happens, then, when there is virtually no market for these assets — as has been true for at least a year? In that case, accounting rules require the banks use whatever market indicators are available.

The banks follow two steps. First, they establish the net realizable value for the portfolio. This is simply what the value of the cash flows would bring in a fully functioning market, including discounts for several factors like anticipated future losses. Paradoxically, many of the banks’ most troubled assets are flowing cash near their expected rates, and thus their net realizable values are higher than the values to which they have been written down.

This is the most misunderstood part of the mark to market debate. Writedowns reduce earnings and Tier 1 capital ONLY if a security is deemed to be Other Than Temporarily Impaired, or OTTI. Generally speaking, a security is Other Than Temporarily Impaired when it becomes probable that they won’t receive the principal and interest payments they estimated at purchase. However, there are numerous areas in the literature on how to apply the guidance and numerous opinions from the various accounting firms. There is uncertainty in the application, and thus, fear of how it will be applied to their existing securities and any securities they may purchase. Consequently, buyers stay on the sidelines. They won’t sell because the market bids don’t reflect the intrinsic value and selling would directly reduce their earnings and capital. They won’t buy because of the uncertainty of both the market and the accounting treatment.

If a security is determined to be other then temporarily impaired, the write down is to “fair value” as defined by SFAS 157. However, there is an equal amount of uncertainty as to what fair value is in a distressed market. SFAS 157 defines fair value as a price in an orderly transaction and not the price you would receive in a distressed or forced sale. However, the FASB continues to suggest that illiquid markets are not necessarily distressed markets, and since the goal is to determine an exit price, the liquidity spreads need to be factored in when determining fair value. Thus, there is uncertainty as to what fair value is when all the sellers are forced sellers because that is the indication of an exit price.

The FASB tried to provide additional guidance on both these matters in the last three months, but it has done little to clarify the accounting uncertainty. Earlier this week, they issued a press release announcing a new project to improve the fair value model; it is unclear as to the direction the project will go. In our opinion, since the definition of fair value assumes an orderly transaction and not a distressed sale, simply clarifying that the extreme liquidity spreads of a distressed market should not be factored in a fair value estimate, would go a long way to remove the accounting fears and preserve capital of the financial institutions. This does not seem to be a major change or suspension of an accounting policy but consistent with the definition.

The securitization market participated in by financial institutions has been a significant part of lending to consumers for homes, autos and credit cards. In addition to the fair value accounting project, the FASB is in the process of reviewing and amending the principal accounting standard on securitization which directly affect how banks account for issuing these securities and purchasing them. The future outcome is still uncertain. The impact of this uncertainty on a bank’s willingness to lend or buy securitized loans cannot be underestimated.

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.

For example, during the 3rd quarter of 2008, FHLB Atlanta’s cash flow projections on approximately $300 million of mortgage-backed securities projected that the credit support from the junior securities would be depleted in approximately 16 to 19 years and the securities would lose approximately $44 thousand dollars beginning in the year 2025. Because the market is inactive and dominated by liquidation sales, these securities were trading at about 70% of par as of September 30. Thus, a $44 thousand projected loss 20 years from now becomes an $87 million loss today based on the accounting rules for securities that are OTTI. These accounting rules only apply to securities as the loss for direct loans held by a bank would require a loss of only $44 thousand. Further, international accounting rules for securities held for investment would also only recognize a $44 thousand dollar loss. Only US GAAP would require an $87 million dollar loss. For further pain, the IRS would not let you recognize that loss for taxes until 2025. Who would buy mortgage-backed securities in this market when those are the rules? How much of the inactive market is due to real credit issues and how much is due to the accounting rules?

Here is the excerpt from FHLB Atlanta’s 10Q in thousands:

Based on the Bank’s impairment analysis at September 30, 2008, the Bank recognized an other-than-temporary impairment loss of $87.3 million related to three private label MBS in its held-to-maturity securities portfolio (the “OTTI Charge”). The Bank recognizes an other-than-temporary impairment when it is probable that the Bank will not collect all scheduled contractual cash flows. The amount of other-than-temporary impairment is calculated as the difference between the current carrying value and the securities’ fair value.

The following table presents the indicated loss of contractual cash flows, the estimated date of first loss of contractual cash flows, and the impairment charge recognized for each of the securities for which an other-than-temporary impairment charge was recognized (in thousands):

It is important that the media follow this issue closely but it is also important that the issues are clearly understood.

We concur with Ed’s statement that the OTTI model used by international accounting standards is superior to the U.S. approach and consistent with all other financial assets.  While the Financial Accounting Standards Board (FASB) is in the process of reviewing mark-to-market rules, they should give this topic of OTTI full consideration. We’ll take it a step further by adding that U.S. GAAP and the International Accounting Standards Board (IASB) have already committed to “converging” their rules over time.

While we understand that this convergence is a step-by-step process and takes time, we believe that prioritizing and immediately modifying U.S. accounting rules on OTTI makes sense since convergence is already forthcoming at some point and this issue needs attention today. The international rules are superior to those of the United States given the punitive nature of the U.S. rules in distressed markets, and the organizations should focus on converging the largest, most pressing issues first.

For more information on OTTI, please watch our video below.

Watch Ed Yingling on CNBC below.